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July 9, 2018 |
New York State Supreme Court Annuls State Title Insurance Regulations

Click for PDF On July 5, 2018, the Manhattan Supreme Court overturned New York State Insurance Regulation 208. The case involved a challenge by the New York State Land Title Association (NYSLTA) to the New York State Department of Financial Services’ (DFS) recently enacted sweeping regulation (Insurance Regulation 208) that would have barred the entire title insurance industry in New York State from engaging in traditional industry marketing practices ranging from a title insurance agent taking a real estate attorney to lunch to hosting an office party. The regulation also would have imposed an across-the-board, industry-wide 5% rate reduction on title insurance premiums, forbid certain title insurance agents from receiving pick-up fees and gratuities, and capped fees charged by the industry for certain ancillary services at 200% of the cost of the service to the title company. Gibson Dunn represented the industry in bringing an Article 78 action challenging these restrictions as contrary to DFS’s governing statutes, arbitrary and capricious, violations of and due process, among other claims, and challenging the entire regulation as outside the scope of DFS’s authority. Gibson Dunn also argued that Insurance Regulation 208 was economically destructive to the industry, and would lead to small businesses closing and people losing their jobs, and was not justified by any record of misconduct by the industry. After briefing and argument, Justice Rakower of New York State Supreme Court issued a detailed decision (click HERE) finding in NYSLTA’s favor on each of the four specific provisions it was challenging, and then struck down Insurance Regulation 208 in its entirety. The court found that DFS had exceeded the scope of its statutory authority and the Legislature never intended for DFS to prohibit “title insurance corporations from marketing themselves for business – an absurd proposition.” The Court also found the various arguments made by DFS in defense of the regulation to be “irreconcilable and irrational,” and “devoid of economic or other analysis” justifying the restrictions imposed by the agency. Gibson Dunn & Crutcher LLP partner Mylan Denerstein and associates Akiva Shapiro and David Coon represented NYSLTA in this action and are available to answer questions regarding the decision. Please feel free to contact the Gibson Dunn lawyer with whom you usually work, or the following Gibson Dunn team members in New York: Mylan L. Denerstein (+1 212-351-3850, mdenerstein@gibsondunn.com) Akiva Shapiro (+1 212-351-3830, ashapiro@gibsondunn.com) David Coon (+1 212-351-2477, dcoon@gibsondunn.com)

June 28, 2018 |
India – Legal and Regulatory Update (June 2018)

Click for PDF The Indian Market The Indian economy continues to be an attractive investment destination and one of the fastest growing major economies. After a brief period of uncertainty, following the introduction of a uniform goods and services tax and the announcement that certain banknotes would cease to be legal tender, the growth rate of the economy has begun to rebound, increasing to 7.7 percent in the first quarter of 2018, up from 6.3 percent in the previous quarter. In the World Bank’s most recent Ease of Doing Business rankings, India climbed 30 spots to enter the top 100 countries. This update provides a brief overview of certain key legal and regulatory developments in India between May 1, 2017 and June 28, 2018. Key Legal and Regulatory Developments Foreign Investment Compulsory Reporting of Foreign Investment: The Reserve Bank of India (“RBI“) has notified a one-time reporting requirement[1] for Indian entities with foreign investment. Each such entity must report its total foreign investment in a specified format (asking for certain basic information such as the entity’s main business activity) no later than July 12, 2018. Indian entities can submit their reports through RBI’s website. Indian entities that do not comply with this requirement will be considered to be in violation of India’s foreign exchange laws and will not be permitted to receive any additional foreign investment. This one-time filing requirement is a precursor to the implementation of a single master form that aims to integrate current foreign investment reporting requirements by consolidating nine separate forms into one single form. Single Brand Retail: The Government of India (“Government“) has approved up to 100% foreign direct investment (“FDI“) in single brand product retail trading (“SBRT“) under the automatic route (i.e., without prior Government approval), subject to certain conditions.[2] Previously, FDI in SBRT entities exceeding 49% required the approval of the Government. The Government has also relaxed local sourcing conditions attached to such foreign investment. SBRT entities with more than 51% FDI continue to be subject to local sourcing requirements in India, unless the entity is engaged in retail trading of products that have ‘cutting-edge’ technology. All such SBRT entities are required to source 30% of the value of goods purchased from Indian sources. The Government has now relaxed this sourcing requirement by allowing such SBRT entities to count any purchases made for its global operations towards the 30% local sourcing requirement for a period of five years from the year of opening its first store. The Government has clarified that this relaxation is limited to any increment in sourcing from India from the preceding financial year to the current one, measured in Indian Rupees. After this five year period, the threshold must be met directly by the FDI-receiving SBRT entity through its India operations, on an annual basis. Real Estate Broking Service: The Government has clarified that real estate broking service does not qualify as real estate business and is therefore eligible to receive up to 100% FDI under the automatic route.[3] Introduction of the Standard Operating Procedure: In mid-2017 the Government abolished the Foreign Investment Promotion Board – the Government body responsible for rendering decisions on FDI investments requiring Government approval. Instead, in order to streamline regulatory approvals, it has introduced the Standard Operating Procedure for Processing FDI Proposals (“SOP“).[4] The Government has designated certain competent authorities who are to process an application for FDI in the sector assigned to them. For example, the Ministry of Civil Aviation is responsible for considering and approving FDI proposals in the civil aviation sector. Under the SOP, the competent authorities must adhere to time limits within which a decision must be given. Significantly, the SOP mandates a relevant competent authority to obtain the DIPP’s concurrence before it rejects an application or imposes conditions on a proposed investment. Mergers and Acquisitions Relaxation of Merger Notification Timelines: Previously, parties to a transaction, regarded as a combination within the meaning of the [Indian] Competition Act, 2002 were required to notify the Competition Commission of India (“CCI“) within 30 days of a triggering event, such as execution of transaction documents or approval of a merger or amalgamation by the board of directors of the combining parties. Now, the CCI has exempted parties to combinations from the 30 day notice requirement until June 2022.[5] This move will provide parties involved in a combination sufficient time to compile a comprehensive notification and will possibly lead to faster approvals by easing the burden on CCI’s case teams. Rules for Listed Companies Involved in a Scheme: The Securities and Exchange Board of India (“SEBI“)’s listing rules requires listed companies involved in schemes of arrangement under the [Indian] Companies Act, 2013 (“Companies Act“), to file a draft version of the scheme with a stock exchange. This is in order to obtain a no objection/observation letter before the scheme can be filed with the National Company Law Tribunal. In March 2017, SEBI issued a revised framework for schemes proposed by listed companies in India. In January 2018, SEBI issued a circular[6] amending the 2017 framework. As a part of the 2018 amendments, SEBI clarified that a no objection/observation letter is not required to be obtained from a recognized stock exchange for a demerger/hive off of a division of a listed company into a wholly owned subsidiary, or a merger of a wholly owned subsidiary into its parent company. However, draft scheme documents will still need to be filed with the stock exchange for the purpose of information. The stock exchange will then disseminate the information on their website. Companies Act Action Against Non-Compliant Companies: Registrars of companies (“RoC“) in various Indian states, acting on powers granted under the Companies Act, have initiated action against companies which have either not commenced operations or have not been carrying on business in the past two years. In September 2017, the Government announced that over 200,000 companies had been struck-off from the register of companies based on the powers described above.[7] Further, the director identification numbers for individuals serving as directors on the board of such companies were cancelled, resulting in their disqualification to serve on the board of any company for a period of five years. The striking-off was targeted at Indian companies that failed to fulfill regulatory and compliance requirements (such as filing annual returns) for three years.[8] Notification of Layering Rules: The Government has notified a proviso to subsection 87[9] of Section 2 of the Companies Act along with the Companies (Restriction on Number of Layers) Rules, 2017 (the “Layering Rules“).[10] The effect of these notifications is that an Indian company which is not a banking company, non-banking financial company, insurance company or a government company, is not allowed to have more than two layers of subsidiaries. For the purposes of computing the number of layers, Indian companies are not required to take into account one layer consisting of one or more wholly owned subsidiaries. Further, the Layering Rules do not prohibit Indian companies from acquiring companies incorporated outside India which have subsidiaries beyond two layers (as long as such a structure is permitted in accordance with the laws of the relevant country). Provisions of Companies Act Extended to all Foreign Companies: India has enacted the Companies (Amendment) Act, 2017 in order to amend various sections of the Companies Act. The provisions of the amendment act are being brought into effect in a phased manner. Recently, the Government has notified a provision in the Companies (Amendment) Act, 2017[11] which extends the applicability of sections 380 to 386 and sections 392 and 393 of the Companies Act to all foreign companies which have a place of business in India or conduct any business activity in the country. Prior to this amendment, these provisions were only applicable to foreign companies where a minimum of fifty percent of the shares were held by Indian individuals or companies. These provisions of the Companies Act include a requirement to (a) furnish information and documents to the RoC, such as certified copies of constitutional documents, the company’s balance sheet and profit and loss account; and (b) comply with the provisions governing issuance of debentures, preparation of annual returns and maintaining books of account. Notification of Cross Border Merger Rules: The Government had notified Section 234 of the Companies Act and Rule 25A of the Companies (Compromises, Arrangements and Amalgamations) Rules 2016. Please refer to our regulatory update dated May 1, 2017 for further details. In this update, we had referred to the requirement of the RBI’s prior permission in order to commence cross border merger procedures under the Companies Act. On March 20, 2018, the RBI issued the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (the “Cross Border Merger Rules“).[12] The Cross Border Merger Rules provide for the RBI’s deemed approval where the proposed cross-border merger is in accordance with the parameters specified by it. These parameters include, where the resultant company is an Indian company, a requirement that any borrowings or guarantees transferred to the resultant entity comply with RBI regulations on external commercial borrowings within a period of two years from the effectiveness of the merger. End-use restrictions under the existing RBI regulations do not have to be complied with. However, where the resultant company is an offshore company, the transfer of any borrowings in rupees to the resultant company requires the consent of the Indian lender and must be in compliance with Foreign Exchange Management Act, 1999 and regulations issued thereunder. In addition, repayment of onshore loans will need to be in accordance with the scheme approved by the National Company Law Tribunal. Currently, these provisions apply only to mergers and amalgamations, and not to demergers. Labour Laws States Begin Implementing Model Labour Law: In mid-2016, the Government introduced the Model Shops and Establishments (Regulation of Employment and Conditions of Service) Bill (“S&E Bill“). The S&E Bill, as is the case with other shops and establishments legislation in India, mandates working hours, public holidays and regulates the condition of workers employed in non-industrial establishments such as shops, restaurants and movie theatres. States in India can either adopt the S&E Bill in its entirety, superseding existing regulations, or choose to amend their existing enactments based on the S&E Bill. The S&E Bill seeks to update Indian laws, adapting them to current business requirement for non-industrial establishments. For example, the S&E Bill (a) enables establishments to remain open 365 days in a year, and (b) allows women to work night shifts, while containing provisions for employers to ensure safety of women workers. Registration provisions under the new legislation have also been eased. In late 2017, the State of Maharashtra notified a new shops and establishments statute based on the S&E Bill.  Other states in India are expected to follow suit. Start–ups Issue of Convertible Notes by Start-ups: The Government had eased funding for start-ups in India in January 2016. Please refer to our regulatory update dated May 18, 2016, for an overview of this initiative. In January 2017, the RBI had permitted start-ups to receive foreign investment through the issue of convertible notes.[13] The revised FDI Policy issued in 2017 now incorporates these provisions. The provisions allow for an investment of INR 2,500,000 (approx. USD 36,700) or more to be made in a single tranche. These notes are repayable at the option of the holder, and convertible within a five year period. The issuance of the notes is subject to entry route, sectoral caps, conditions, pricing guidelines and other requirements that are prescribed for the sector by the RBI.[14] Capital Gains Tax Charging of Long Term Capital Gains Tax: An important amendment to Indian tax laws introduced by the Finance Act, 2018[15] is the levy of tax at the rate of 10% on capital gains made on the sale of certain securities (including listed equity shares) held at least for a year. The tax is levied if the total amount of capital gains exceeds INR 100,000 (approx. USD 1,448). This amendment came into effect on April 1, 2018. However, all gains made on existing holdings until January 31, 2018 are exempt from the tax.  In all such ‘grandfathering’ cases, the cost of acquisition of a security is deemed to be the higher of the actual cost of acquisition and the fair market value of the security as on January 31, 2018. Where the consideration received on transfer of the security is lower than the fair market value as on January 31, 2018, the cost of acquisition is deemed to be the higher of the actual cost of acquisition and the consideration received for the transfer.[16] [1] RBI Notification on Reporting in Single Master Form dated June 7, 2018. Available at https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NT194481067EB1B554402821A8C2AB7A52009.PDF [2] Press Note No. 1 (2018 Series) dated January 23, 2018, Department of Industrial Policy & Promotion, Ministry of Commerce & Industry, Government of India. [3] Id.  [4] Standard Operating Procedure dated June 29, 2017. Available at http://www.fifp.gov.in/Forms/SOP.pdf  [5] MCA Notification dated June 29, 2017. Available at http://www.cci.gov.in/sites/default/files/notification/S.O.%202039%20%28E%29%20-%2029th%20June%202017.pdf  [6] SEBI Circular dated January 3, 2018. Available at https://www.sebi.gov.in/legal/circulars/jan-2018/circular-on-schemes-of-arrangement-by-listed-entities-and-ii-relaxation-under-sub-rule-7-of-rule-19-of-the-securities-contracts-regulation-rules-1957-_37265.html. [7] Press Information Bureau, Government of India, Ministry of Finance, “Department of Financial Services advises all Banks to take immediate steps to put restrictions on bank accounts of over two lakh ‘struck off’ companies”, http://pib.nic.in/newsite/PrintRelease.aspx?relid=170546 (September 5, 2017). [8] Live Mint, “Govt blocks bank accounts of 200,000 dormant firms”, http://www.livemint.com/Companies/oTcu9b66rZQnvFw6mgSCGK/Black-money-Bank-accounts-of-209-lakh-companies-frozen.html (September 6, 2017).  [9] MCA Notification vide S.O. No. 3086(E) dated September 20, 2017.  [10] Notification No. G.S.R. 1176(E) dated September 20, 2017. Available at http://www.mca.gov.in/Ministry/pdf/CompaniesRestrictionOnNumberofLayersRule_22092017.pdf[11] MCA Notification dated February 9, 2018. Available at http://www.mca.gov.in/Ministry/pdf/Commencementnotification_12022018.pdf [12] FEMA Notification dated March 20, 2018. Available at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CBM28031838E18A1D866A47F8A20201D6518E468E.pdf  [13] RBI Notification of changes to RBI regulations dated January 10, 2017. Available at https://rbi.org.in/scripts/NotificationUser.aspx?Id=10825&Mode=0 [14] Consolidated FDI Policy Circular of 2017. Available at http://dipp.nic.in/sites/default/files/CFPC_2017_FINAL_RELEASED_28.8.17.pdf [15] Section 33 of the Finance Act, 2018. Available at http://egazette.nic.in/writereaddata/2018/184302.pdf [16] CBDT Notification No. F. No. 370149/20/2018-TPL. Available at https://www.incometaxindia.gov.in/news/faq-on-ltcg.pdf Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. For further details, please contact the Gibson Dunn lawyer with whom you usually work or the following authors in the firm’s Singapore office: India Team: Jai S. Pathak (+65 6507 3683, jpathak@gibsondunn.com) Karthik Ashwin Thiagarajan (+65 6507 3636, kthiagarajan@gibsondunn.com) Prachi Jhunjhunwala (+65.6507.3645, pjhunjhunwala@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 25, 2018 |
Gibson Dunn Receives Chambers USA Excellence Award

At its annual USA Excellence Awards, Chambers and Partners named Gibson Dunn the winner in the Corporate Crime & Government Investigations category. The awards “reflect notable achievements over the past 12 months, including outstanding work, impressive strategic growth and excellence in client service.” This year the firm was also shortlisted in nine other categories: Antitrust, Energy/Projects: Oil & Gas, Energy/Projects: Power (including Renewables), Intellectual Property (including Patent, Copyright & Trademark), Labor & Employment, Real Estate, Securities and Financial Services Regulation and Tax team categories. Debra Wong Yang was also shortlisted in the individual category of Litigation: White Collar Crime & Government Investigations. The awards were presented on May 24, 2018.  

May 24, 2018 |
Dodd Frank 2.0: Reforming U.S. HVCRE Capital Treatment

Click for PDF On Tuesday, May 22, 2018, the U.S. House of Representatives passed the Economic Growth, Regulatory Relief, and Consumer Protection Act (Reform Bill), which had already passed the Senate on a bipartisan basis.  President Trump signed the Reform Bill into law today.  Among the Reform Bill’s more important provisions is a section reforming the current capital treatment of so-called High Volatility Commercial Real Estate (HVCRE) loans.  The Reform Bill, in provisions that are now effective, overrides certain highly conservative provisions in both the federal banking agencies’ (Banking Agencies) Basel III capital rule and their interpretations of it. HVCRE Capital Treatment Under the Basel III Capital Rule and the Banking Agencies’ Interpretations Current HVCRE treatment is a purely American phenomenon; it was not included in the international Basel III framework.  A form of capital “gold plating,” it imposes a 50% heightened capital treatment on certain commercial real estate loans that are characterized as HVCRE loans. The current Basel III capital rule defines an HVCRE loan as follows: A credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances: One- to four-family residential properties; Certain community development properties The purchase or development of agricultural land, provided that the valuation of the agricultural land is based on its value for agricultural purposes and the valuation does not take into consideration any potential use of the land for non-agricultural commercial development or residential development; or Commercial real estate projects in which: The loan-to-value ratio is less than or equal to the applicable maximum supervisory loan-to-value ratio under Banking Agency standards – e.g., 80% for a commercial construction loan; The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15% of the real estate’s appraised ”as completed” value; and The borrower contributed the amount of capital required  before the bank advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.[1] Under the current Basel III capital rule, the life of a project concludes only when the credit facility is converted to permanent financing or is sold or paid in full.[2] The current Basel III capital rule has raised many interpretative questions; however, many of the important ones have not been answered by the Banking Agencies, and others have been answered in a non-intuitive, unduly conservative manner.  In particular, the Banking Agencies interpreted the requirement relating to internally generated capital as foreclosing distributions of such capital even if the amount of capital in the project exceeds 15% of “as completed” value post-distribution.[3]  The Banking Agencies also have not permitted appreciated land value to be taken into account for purposes of the borrower’s capital contribution. The Reform Bill’s Principal Provisions The Reform Bill overrides the current Basel III capital rule.[4]  Specifically, it states that the Banking Agencies may impose a heightened capital charge on an HVCRE loan (as currently defined) only if the loan is also an HVCRE ADC loan.  Such a loan is defined as: A credit facility secured by land or improved real property that, prior to being reclassified by the depository institution as a non-HVCRE ADC loan— (A) primarily finances, has financed, or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility. Thus the loan must not only finance or refinance the acquisition, development, or construction of real property, it must “primarily” do so, must have a development purpose, and must be dependent on future income, sales proceeds or refinancing – not current income.  The “HVCRE ADC” loan definition also corrects some of the unduly conservative regulatory interpretations described above.  It permits appreciated land value, as determined by a qualifying appraisal, to be taken into account for purposes of the 15% test, and it permits capital to be withdrawn as long as the 15% test continues to be met. In addition, the Reform Bill overrides the current Basel III capital rule by stating that HVCRE status may end prior to the replacement of the ADC loan with permanent financing, upon: the substantial completion of the development or construction of the real property being financed by the credit facility; and cash flow being generated by the real property being sufficient to support the debt service and expenses of the real property, in accordance with the bank’s applicable loan underwriting criteria for permanent financings.[5] Additional exemptions from HVCRE treatment apply to loans for: the acquisition or refinance of existing income-producing real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings; and improvements to existing income-producing improved real property secured by a mortgage on such property, if the cash flow being generated by the real property is sufficient to support the debt service and expenses of the real property, in accordance with the institution’s applicable loan underwriting criteria for permanent financings. Finally, loans made prior to January 1, 2015 may not be classified as HVCRE loans. Conclusion The Reform Bill’s HVCRE ADC provisions are a welcome development.  They do not answer every question relating to HVCRE treatment, but they do purge regulatory interpretations that led to heightened capital treatment for many ADC loans in the absence of persuasive risk justifications.  It is to be hoped that the Banking Agencies further the legislation’s intent of aligning gold plated capital treatment more closely to risk when interpreting the new law.    [1]   See, e.g., 12 C.F.R. § 3.2.    [2]   Id.    [3]   See Interagency HVCRE FAQ Response 15.  It remains unclear how this interpretation squares with the text of the HVCRE regulation itself.    [4]   The original version of the Senate bill, which was passed first, did not include this provision.  Senator Tom Cotton, R-Ark, proposed the relevant amendment while the Senate was considering the bill.    [5]   The Reform Bill retains the current exemptions for loans financing one- to four-family residential properties, certain community development properties, and the purchase or development of agricultural land. The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long and James Springer. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or any of the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Real Estate and Finance Groups: Jesse Sharf – Los Angeles (+1 310-552-8512, jsharf@gibsondunn.com) Eric M. Feuerstein – New York (+1 212-351-2323, efeuerstein@gibsondunn.com) Erin Rothfuss – San Francisco (+1 415-393-8218, erothfuss@gibsondunn.com) Aaron Beim – New York (+1 212-351-2451, abeim@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213-229-7582, lcurtis@gibsondunn.com) Drew C. Flowers – Los Angeles (+1 213-229-7885, dflowers@gibsondunn.com) Noam I. Haberman – New York (+1 212-351-2318, nhaberman@gibsondunn.com) Victoria Shusterman – New York (+1 212-351-5386, vshusterman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 4, 2018 |
Real Estate Finance Partner Kahlil Yearwood Joins Gibson Dunn in San Francisco

Gibson, Dunn & Crutcher LLP is pleased to announce that Kahlil T. Yearwood has joined the firm’s San Francisco office as a partner.  Yearwood, formerly with Dechert LLP, continues his real estate finance practice at Gibson Dunn. “We welcome Kahlil to the firm,” said Ken Doran, Chairman and Managing Partner of Gibson Dunn.  “He is one of the top lender side real estate finance lawyers in the country.  His addition to our San Francisco office will complement the recent growth of our real estate debt capabilities in our New York office and solidify our standing as one of the preeminent real estate practices in the country.” “Our lawyers have frequently been opposite Kahlil on transactions in the past and consider him one of the best lender lawyers in the Bay Area and nationally,” said Erin Rothfuss, a San Francisco partner and Co-Chair of the firm’s Real Estate Practice Group.  “He has a vibrant practice, and his addition will bolster our dominant position in the real estate sector and help create a bicoastal real estate finance platform that is second to none.” “I am delighted to be joining Gibson Dunn,” said Yearwood.  “The firm has an impressive real estate presence on both coasts, and this premiere national platform will give me a strong foundation to grow my practice.” About Kahlil Yearwood Yearwood practices real estate finance with a focus on representing lenders in every phase of the life cycle of loans secured directly or indirectly by all types of commercial real estate, including loan origination, loan purchases, loan sales, financing and leverage transactions, post-closing loan modifications, and loan workouts.  His clients include all types of commercial real estate lenders, including commercial banks, life insurance companies, CMBS lenders, specialty finance companies, debt funds, mortgage REITs, servicers, and hedge funds. He is a Fellow of the American College of Mortgage Attorneys and a member of the Commercial Real Estate Finance Council. Prior to joining the firm, Yearwood practiced with Dechert since 2005.  He received his law degree in 2005 from the University of California, Berkeley.

March 20, 2018 |
Supreme Court Approves Deferential Review of Bankruptcy-Court Determinations on “Insider” Status

Click for PDF On March 5, 2018, the U.S. Supreme Court issued a decision in U.S. Bank N.A. Trustee, By and Through CWCapital Asset Management LLC v. Village at Lakeridge, LLC (No. 15-1509), approving the application of the clear error standard of review in a case determining whether someone was a “non-statutory” insider under the Bankruptcy Code. We note that the Court’s narrow holding only addressed the appropriate standard of review, leaving for another day the question of whether the specific test that the Ninth Circuit used to determine whether the individual was a “non-statutory” insider was correct. The ruling is significant, however, because without the prospect of de novo review, a bankruptcy court’s ruling on whether a person is a “non-statutory” insider will be very difficult to overturn on appeal—which may have significant impact on case outcomes. The Bankruptcy Code “Insider” The Bankruptcy Code’s definition of an insider includes any director, officer, or “person in control” of the entity.[1] This definition is non-exhaustive, so courts have devised tests for identifying other, so-called “non-statutory” insiders, focusing, in whole or in part, on whether a person’s transactions with the debtor were at arm’s length. Background In this case, the debtor (Lakeridge) owed money to two main entities, its sole owner MBP Equity Partners for $2.76 million, and U.S. Bank for $10 million. Lakeridge submitted a plan of reorganization, but it was rejected by U.S. Bank. Lakeridge then turned to the “cramdown” option for imposing a plan impairing the interests of non-consenting creditors. This option requires that at least one impaired class of creditors vote to accept the plan, excluding the votes of all insiders. As the debtor’s sole owner, MBP plainly was an insider of the debtor, within the statutory definition of Bankruptcy Code §101(31)(B)(i)–(iii), so its vote would not count. Therefore, to gain the consent of the MBP voting block to pass the cramdown plan, Kathleen Bartlett (an MPB board member and Lakeridge officer), sold MPB’s claim of $2.76 million to a retired surgeon named Robert Rabkin, for $5,000. Rabkin agreed to buy the debt owed to MBP for $5,000 and proceeded to vote in favor of the proposed plan as a non-insider creditor. U.S. Bank, the other large creditor, objected, arguing that the transaction was a sham and pointing to a pre-existing romantic relationship between Rabkin and Bartlett. If Rabkin were an officer or director of the debtor, Rabkin’s status as an insider would have been undisputed. But because Rabkin had no formal relationship with the debtor, the bankruptcy court had to consider whether the particular relationship was close enough to make him a “non-statutory” insider. The bankruptcy court held an evidentiary hearing and concluded that Rabkin was not an insider, based on its finding that Rabkin and Bartlett negotiated the transaction at arm’s length. Because of this decision, the Debtor was able to confirm a cramdown plan over the objection of the senior secured lender. The Ninth Circuit affirmed the bankruptcy court’s ruling, holding that that the finding was entitled to clear-error review, and therefore would not be reversed. The Supreme Court Holds That the Standard of Review Is Clear Error On certiorari, the Supreme Court, in a unanimous opinion, took pains to emphasize that the sole issue on appeal was the appropriate standard of review, and not any determination of the merits of the “non-statutory” insider test that the Ninth Circuit had applied to determine whether Rabkin was an insider. The Supreme Court held that the Ninth Circuit was correct to review the bankruptcy court’s determination for “clear error” (rather than de novo). The Court discussed the difference between findings of law—which are reviewed de novo—and findings of fact—which are reviewed for clear error. The question in this case—whether Rabkin met the legal test for a non-statutory insider—was a “mixed” question of law and fact. Courts often review mixed questions de novo when they “require courts to expound on the law, particularly by amplifying or elaborating on a broad legal standard.”[2] Conversely, courts use the clearly erroneous standard for mixed questions that “immerse courts in case-specific factual issues.”[3] In sum, the Court explained, “the standard of review for a mixed question all depends on whether answering it entails primarily legal or factual work.”[4] Choosing between those two characterizations, the Court chose the latter. The basic question in this case was whether “[g]iven all the basic facts found, Rabkin’s purchase of MBP’s claim [was] conducted as if the two were strangers to each other.”[5] Because “[t]hat is about as factual sounding as any mixed question gets,”[6] the Court held that the clear error standard applied. The Supreme Court Avoids Adjudicating a Potentially Significant Circuit Split on Tests Used to Determine Non-Statutory Insiders All nine of the justices joined Justice Kagan’s opinion. However, the concurring opinion from Justice Sonia Sotomayor (joined by Justices Anthony Kennedy, Clarence Thomas and Neil Gorsuch) suggests grave doubts about the coherence of the Ninth Circuit’s standard for assessing non-statutory-insider status. Nevertheless, Justice Sotomayor agreed that resolving the propriety of that standard is not a task that warranted the Supreme Court’s attention. Impact of US Bank While this case does not break new ground, it firmly establishes the bankruptcy courts’ authority to make these determinations and limits appellate review. This opinion may embolden appellants (and bankruptcy courts) to push the envelope in the future. Debtors may be emboldened to seek to use a variety of affiliate-transaction structures as they seek the keys to confirming cramdown plans over the objections of senior lenders.    [1]   11 U.S.C. § 101(31)(B)(i)–(iii).    [2]   Decision at p. 8.    [3]   Ibid.    [4]   Id. at p. 2.    [5]   Id. at p. 10.    [6]   Ibid. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Samuel A.  Newman – Los Angeles (+1 213-229-7644, snewman@gibsondunn.com) Daniel B. Denny – Los Angeles (+1 213-229-7646, ddenny@gibsondunn.com) Sara Ciccolari-Micaldi – Los Angeles (+1 213-229-7887, sciccolarimicaldi@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

March 5, 2018 |
Supreme Court Settles Circuit Split Concerning Bankruptcy Code “Safe Harbor”

Click for PDF On February 27, 2018, the U.S. Supreme Court issued a decision in Merit Management Group, LP v. FTI Consulting, Inc. (No. 16-784), settling a circuit split regarding the “safe harbor” provision in § 546(e) of the Bankruptcy Code.  That section bars the avoidance of certain types of securities and commodities transactions that are made by, to or for the benefit of covered entities including financial institutions, stockbrokers and securities clearing agencies. Circuits had split regarding whether the safe harbor protects a transfer that passes through a covered entity, where the entity only acts as a conduit and has no beneficial interest in the property transferred.  In Merit Management, the Court held that the safe harbor does not apply when a covered entity only acts as a conduit, and that the safe harbor only applies when the “relevant transfer” (i.e., the “overarching” transfer sought to be avoided) is by, to or for the benefit of a covered entity.  As a result, the Court held that the safe harbor did not protect a private securities transaction where neither the buyer nor the seller was a covered entity, even though the funds passed through covered entities. The Bankruptcy Code “Safe Harbor” The Bankruptcy Code permits a trustee to bring claims to “avoid” (or undo) for the benefit of the bankruptcy estate certain prepetition transfers or obligations, including claims to avoid a preference (11 U.S.C. § 547) or fraudulent transfer (11 U.S.C. § 548(a)).  Section 546(e) limits those avoidance powers by providing that, “[n]otwithstanding” the trustee’s avoidance powers, “the trustee may not avoid a transfer that is” (1) a “margin payment” or “settlement payment” “made by or to (or for the benefit of)” a covered entity, or (2) “a transfer made by or to (or for the benefit of)” a covered entity “in connection with a securities contract . . . or forward contract.”  11 U.S.C. § 546(e).  The sole exception to the safe harbor is a claim for “actual fraudulent transfer” under § 548(a)(1)(A).  Id. Background Merit Management involved the acquisition of a “racino” (a combined horse racing and casino business) by its competitor.  To consummate the transaction, the buyer’s bank wired $55 million to another bank that acted as a third-party escrow agent, which disbursed the funds to the seller’s shareholders in exchange for their stock in the seller.  The buyer subsequently filed for Chapter 11 bankruptcy protection and a litigation trust was established pursuant to the buyer’s confirmed reorganization plan.  The trustee sued one of the selling shareholders that received $16.5 million from the buyer, alleging that the transaction was a constructive fraudulent transfer under § 548(a)(1)(B) because the buyer was insolvent at the time of the purchase and “significantly overpaid” for the stock. The district court held that the safe harbor barred the fraudulent transfer claim because the transaction was a securities settlement payment involving intermediate transfers “by” and “to” covered entities (the banks).  The Seventh Circuit reversed, holding that the safe harbor did not apply because the banks only acted as conduits and neither the buyer nor the shareholder was a covered entity.  In so holding, the Seventh Circuit diverged from other circuits that had applied the safe harbor to transactions consummated through a covered entity acting as a conduit.[1]  Those circuits interpreted the disjunctive language in the safe harbor that protects transfers “by or to (or for the benefit of)” a covered entity to mean that a transfer “by” or “to” a covered entity is protected even if the transfer is not “for the benefit of” the covered entity.  The Supreme Court granted certiorari to settle the circuit split. The Supreme Court Holds That the Safe Harbor Does Not Protect a Transfer When a Covered Entity Only Acts as a Conduit   The Supreme Court affirmed the Seventh Circuit’s decision, holding that the safe harbor does not protect a transfer when a covered entity only acts as a conduit.  The crux of the decision is that a safe harbor analysis must focus on whether the “relevant transfer,” meaning the “overarching” or “end-to-end” transfer that the trustee seeks to avoid, was by, to or for the benefit of a covered entity.  Whether an intermediate or “component” transfer was made by or to a covered entity is “simply irrelevant to the analysis under § 546(e).”[2]  The Court reasoned that, as an express limitation on the trustee’s avoidance powers, § 546(e) must be applied in relation to the trustee’s exercise of those powers with respect to the transfer that the trustee seeks to avoid, not component transfers that the trustee does not seek to avoid.[3]  In the case before it, because the trustee sought to avoid the “end-to-end” transfer from the buyer to the shareholder, and neither was a covered entity, the safe harbor did not apply. The Court Avoids Adjudicating a Potentially Significant Defense The shareholder did not argue in the lower courts that the buyer or the shareholder was a covered entity.  In its briefing in the Supreme Court, the shareholder argued that the buyer and seller were both covered entities because they were customers of the banks that facilitated the transaction, and the definition of “financial institution” in 11 U.S.C. § 101(22)(A) includes a “customer” of a financial institution when the institution “is acting as agent or custodian for a customer.”  During oral argument, Justice Breyer indicated that he might have been receptive to that potentially dispositive argument.  However, the decision expressly avoids adjudicating the argument on the basis that the shareholder raised the point “only in footnotes and did not argue that it somehow dictates the outcome in this case.”  Id. at n. 2.  As a result, the “customer-as-financial-institution defense” will likely be litigated in the lower courts going forward. Impact of Merit Management As a result of Merit Management, parties to securities and commodities transactions should expect that, in the event of a bankruptcy filing, the safe harbor will not protect a transaction unless the transferor, transferee or beneficiary of the “overarching” transfer is a covered entity.  Routing a transfer through a covered entity will no longer protect the transaction.  Given the increased importance placed on whether a party to the overarching transfer is a covered entity, Merit Management may lead to a new wave of litigation regarding the scope of the covered entities, including the circumstances in which the customer of a financial institution constitutes a covered entity, and related planning strategies to fall within such scope.    [1]   See, e.g., In re Quebecor World (USA) Inc., 719 F. 3d 94, 99 (2d Cir. 2013); In re QSI Holdings, Inc., 571 F. 3d 545, 551 (6th Cir. 2009); Contemporary Indus. Corp. v. Frost, 564 F. 3d 981, 987 (8th Cir. 2009); In re Resorts Int’l, Inc., 181 F. 3d 505, 516 (3d Cir. 1999); In re Kaiser Steel Corp., 952 F. 2d 1230, 1240 (10th Cir. 1991).    [2]   Decision at p. 14.    [3]   See id. at pp. 11-14 (“If a trustee properly identifies an avoidable transfer . . . the court has no reason to examine the relevance of component parts when considering a limit to the avoiding power, where that limit is defined by reference to an otherwise avoidable transfer, as is the case with §546(e). . . .”). Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Oscar Garza – Orange County, CA (+1 949-451-3849, ogarza@gibsondunn.com) Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) Douglas G Levin – Orange County, CA (+1 949-451-4196, dlevin@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

February 6, 2018 |
New Threat of Substantive Consolidation for Real Estate Lending Structures

Groundbreaking Ninth Circuit Decision Declares Only One Class of Impaired, Consenting Creditors Is Needed to Confirm a Joint Plan Among Multiple Debtors   Click for PDF The Ninth Circuit’s recent opinion in In re Transwest Resort Properties, Inc. is the first circuit-level decision to address whether, under section 1129(a)(10) of the Bankruptcy Code, a multi-debtor joint chapter 11 plan can be “crammed down” with the consent of a single impaired class (the “per plan” interpretation), or whether a class of creditors from each individual debtor entity must consent (“per debtor”).[1] By adopting the per plan approach, Transwest puts creditors on notice that those who stand to lose out from chapter 11 plans that effectively ignore the separateness of related corporate entities—most notably, secured lenders in real estate financings—should be prepared to challenge those schemes as de facto substantive consolidation rather than relying on the voting requirements of section 1129(a)(10) for protection. Before Transwest: Whose Votes Do We Need, Anyway? In 2011, a Delaware bankruptcy court was the first to examine 11 U.S.C. § 1129(a)(10)—which provides that a plan of reorganization may only be confirmed if “at least one class of claims that is impaired under the plan has accepted the plan”—and conclude that this requirement must be met separately for each debtor entity included in a joint plan of reorganization.[2] In In re Tribune Co., Judge Kevin Carey held that a per plan interpretation of section 1129(a)(10) was irreconcilable with the principle that “[i]n the absence of substantive consolidation, entity separateness is fundamental.”[3] Moreover, he observed that a per debtor approach would be consistent with the other provisions of section 1129(a), e.g. the “best interest of creditors” requirement of section 1129(a)(7), which also must be satisfied on a per debtor basis.[4] While the court acknowledged that it might be challenging to obtain debtor-by-debtor consent in a complex case like Tribune, in which two competing joint plans would have reorganized over one hundred affiliated debtors, it concluded that “convenience alone is not sufficient reason to disturb the rights of impaired classes of creditors of a debtor not meeting confirmation standards.” In Tribune, both proposed joint plans contained provisions stating that they were not premised on substantive consolidation, the doctrine which, in certain circumstances, permits chapter 11 plans to treat liabilities of multiple affiliated debtors as liabilities of a single consolidated entity. As Judge Carey observed, such provisions are “not uncommon,” presumably because plan proponents wish to avoid an expensive battle to impose substantive consolidation, proponents of which face a heavy evidentiary burden within bankruptcy courts in the Third Circuit as a result of the circuit-level decision in In re Owens Corning.[5] In the absence of substantive consolidation, the Tribune court concluded that the joint plan in question “actually consists of a separate plan for each Debtor,” and each such plan must separately satisfy the confirmation requirements of section 1129(a).[6] Because several courts had previously held that section 1129(a)(10) could be satisfied on a per plan basis,[7] the decision in Tribune created a split of authority. While one subsequent Delaware case has followed the per debtor approach of Tribune, the Arizona bankruptcy court overseeing the chapter 11 cases of Transwest Resort Properties Inc. and its subsidiaries chose to adopt the per plan interpretation of the statute, setting in motion a string of appeals that led to the Ninth Circuit’s recent precedent-setting decision.[8] The Transwest Chapter 11 Cases Compared to the conglomeration of affiliated debtors in Tribune, the debtors in Transwest were relatively few in number and straightforward in purpose. The underlying assets were two resort hotel properties in Tucson, AZ and Hilton Head, SC, each owned by an operating company (together, the “OpCo Debtors”), and each subject to a single senior mortgage with the OpCo Debtor as the sole obligor.[9] The equity of each OpCo Debtor was 100% owned by a holding company (together, the “Mezzanine Debtors”) each of which incurred additional financing secured by equity in the corresponding OpCo. At the top of the corporate structure was a holding company that owned 100% of the equity of the Mezzanine Debtors. When all five entities filed for chapter 11 bankruptcy in 2010, the owner of the OpCo mortgage debt (the “Lender”) filed proofs of claim against the OpCo Debtors totaling $209 million, while secured claims against the Mezzanine Debtors (claims which the Lender eventually acquired) totaled $39 million. In March 2011, the Lender sought relief from the automatic stay in order to foreclose on its mortgage loans against the OpCo Debtors. The bankruptcy court denied this request, and also denied a June 2011 request to foreclose on the mezzanine debt, paving the way for the five Transwest debtors to propose a joint plan of reorganization (the “Plan”). Under the Plan, a third party would invest $30 million in exchange for the Mezzanine Debtors’ ownership interests in the OpCo Debtors, while the Lender’s senior mortgage debt would be repaid in smaller monthly installment over a longer period.[10] The Lender, which by this time was the also the sole creditor of the Mezzanine Debtors, sought to block confirmation of the plan, arguing, inter alia, that, since section 1129(a)(10) requires the consent of a dissenting class from each debtor, the Plan could not be confirmed without the Lender’s consent. Both the bankruptcy court and, on appeal, the district court concluded that the “per debtor” interpretation of section 1129(a)(10) set forth in Tribune was not persuasive, and that the plain language of the statute supported the per plan approach: The statute states that “[i]f a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan” then the court shall confirm the plan if additional requirements are met. 11 U.S.C. § 1129(a)(10) (emphasis added). Thus, once an impaired class has accepted the plan, § 1129(a)(10) is satisfied as to all debtors because all debtors are being reorganized under a joint plan of reorganization.[11] With five of ten classes having voted in favor of the joint Plan in Transwest, the lower courts concluded that section 1129(a)(10) was no obstacle to confirmation, notwithstanding the fact that the Lender, the sole creditor of the Mezzanine Debtors, had withheld its consent. The Ninth Circuit’s Decision in Transwest The Lender appealed to the Ninth Circuit, which became the first federal court of appeals to address whether the strictures of section 1129(a)(10) apply on a per debtor basis or per plan basis.[12] The panel of three judges unanimously affirmed the lower courts’ per plan interpretation of the statute. In a succinct opinion, Judge Milan Smith wrote that the plain language of section 1129(a) supported the per plan approach, and that neither the statutory context nor applicable rules of statutory construction altered this reading.[13] Acknowledging the Lender’s concerns that the per plan approach would lead to a “parade of horribles” for similarly situated real estate lenders, the court observed that these were policy concerns best resolved by Congress. Moreover, to the extent that Lenders now argued that the Transwest debtors’ Plan was, in effect, an impermissible substantive consolidation, the court declined to consider this argument since it was raised for the first time on appeal.[14] In a separate concurrence, Judge Friedland wrote to emphasize that she shared some of the Lender’s concerns with respect to substantive consolidation, though she agreed that the Lender waived them by failing to raise them earlier. Judge Friedland observed that, although the Plan provided that the various debtors “technically . . . remained separate,” distributions under the Plan were devised such that “creditors for different Debtors all drew from the same pool of assets.”[15] Given that this kind of de facto substantive consolidation is a common feature of joint plans with multiple related debtors, Judge Friedland emphasized that creditors who believe they lose out from consolidation of the debtors’ assets and liabilities should make their objections promptly and clearly in the bankruptcy courts: [I]f a creditor believes that a reorganization improperly intermingles different estates, the creditor can and should object that the plan—rather than the requirements for confirming the plan—results in de facto substantive consolidation. Such an approach would allow this issue to be assessed on a case-by-case basis, which would be appropriate given the fact-intensive nature of the substantive consolidation inquiry.[16] Conclusion While the Ninth Circuit’s opinion in Transwest provides a measure of comfort for plan proponents with respect to the voting requirements of section 1129(a)(10), it may foreshadow battles to come over de facto substantive consolidation. Moreover, for debtors and creditors in chapter 11 cases outside the Ninth Circuit, it remains to be seen whether bankruptcy courts will follow the per plan approach endorsed in Transwest, or whether the per debtor approach of Tribune will gain new adherents. In the meantime, mezzanine lenders and other creditors whose rights are threatened by multi-debtor plans of reorganization would be well-advised to raise both objections, lest they should find themselves in the unfortunate position of the Lender in Transwest, wondering whether they waived a winning argument. Failure to raise an argument in respect of a chapter 11 plan’s attempt to impermissibly substantively consolidate a multi-debtor estate may frustrate the entire purpose of the senior/mezzanine financing structure, which is to isolate the collateral—and claims—of the senior lender and the mezzanine lender at the appropriate legal entity, and to limit their remedies accordingly. The “per plan” approach, requiring only one impaired accepting class, could result in creditors of a mezzanine debtor determining the treatment of the senior lender’s claim at the opco debtor over the senior lender’s objection.[17] For borrowers and guarantors, the Transwest decision may incentivize parties to file chapter 11 bankruptcy within the Ninth Circuit. Debtors may be able to confirm a plan over the objections of certain creditor groups using the “cram down” mechanism affirmed by the Transwest decision’s interpretation of Section 1129(a)(10).    [1]   In re Transwest Resort Properties, Inc. (JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Properties, Inc.), No. 16-16221, 2018 WL 615431 (9th Cir. Jan. 25, 2018). The Ninth Circuit addressed a second question in Transwest not discussed in this client alert, namely, whether a secured lender’s election to have its entire claim treated as secured under 11 U.S.C. § 1111(b)(2) requires a due-on-sale clause to be included in a debtor’s plan of reorganization. The Ninth Circuit’s opinion, which is marked for publication, is also available for download at http://cdn.ca9.uscourts.gov/datastore/opinions/2018/01/25/16-16221.pdf.    [2]   In re Tribune Co., 464 B.R. 126, 183 (Bankr. D. Del. 2011).    [3]   Id. at 182 (citing In re Owens Corning, 419 F.3d 195, 211 (3d Cir. 2007)).    [4]   Tribune, 464 B.R. at 182.    [5]   In re Owens Corning, 419 F.3d 195, 211–12 (3d Cir. 2007) (“The upshot is this. In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (i) prepetition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. Proponents of substantive consolidation have the burden of showing one or the other rationale for consolidation.”).    [6]   Tribune, 464 B.R. at 182.    [7]   See, e.g., In re SGPA, Inc., 2001 Bankr.LEXIS 2291 (Bankr. M.D. Pa. Sep. 28, 2001); In re Charter Commc’ns, 419 B.R. 221 (Bankr. S.D.N.Y. 2009).    [8]   In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 293 (Bankr. D. Del. 2011); In re: Transwest Resort Properties, Inc., 554 B.R. 894 (D. Ariz. 2016).    [9]   In re Transwest Resort Properties, Inc., 554 B.R. 894, 896–97 (D. Ariz. 2016). [10]   Id. at 897. [11]   Id. at 901. [12]   The Lender also appealed the lower court’s ruling that Section 1111(b) did not require the inclusion of a due-on-sale clause in the Plan, which the Court affirmed. Accordingly, even though the Lender was entitled to be treated as fully secured under the Plan, the Lender was not entitled to certain covenants and restrictions related to the disposition of its collateral under the terms of the Plan. [13]   In re Transwest Resort Properties, Inc., No. 16-16221, 2018 WL 615431 at *5 (9th Cir. Jan. 25, 2018). (“[T]he Lender provides no support for its position that all subsections [of section 1129(a)] must uniformly apply on a “per debtor” basis.”) [14]   Id. [15]   Id. at *6 (Friedland, J., concurring). [16]   Id. at *8 (citing In re Bonham, 229 F.3d at 765 (“[O]nly through a searching review of the record, on a case-by-case basis, can a court ensure that substantive consolidation effects its sole aim: fairness to all creditors.”)) [17]   The Ninth Circuit’s endorsement of the “per plan” interpretation of section 1129(a)(10) may also prompt renewed attention toward the bankruptcy provisions, including the voting rights with respect to each borrower’s bankruptcy case, in an intercreditor agreement between senior lender and mezzanine lender. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues.  For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following authors: Matthew K. Kelsey – New York (+1 212-351-2615, mkelsey@gibsondunn.com) Samuel A.  Newman – Los Angeles (+1 213-229-7644, snewman@gibsondunn.com) Daniel B. Denny – Los Angeles (+1 213-229-7646, ddenny@gibsondunn.com) Michael K. Gocksch – Los Angeles (+1 213-229-7076, mgocksch@gibsondunn.com) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) David M. Feldman – New York (+1 212-351-2366, dfeldman@gibsondunn.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, jkrause@gibsondunn.com) Robert A. Klyman – Los Angeles (+1 213-229-7562, rklyman@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 7, 2018 |
2017 Year-End German Law Update

Click for PDF “May you live in interesting times” goes the old Chinese proverb, which is not meant for a friend but for an enemy. Whoever expressed such wish, interesting times have certainly come to pass for the German economy. Germany is an economic giant focused on the export of its sophisticated manufactured goods to the world’s leading markets, but it is also, in some ways, a military dwarf in a third-tier role in the re-sketching of the new world order. Germany’s globally admired engineering know-how and reputation has been severely damaged by the Volkswagen scandal and is structurally challenged by disruptive technologies and regulatory changes that may be calling for the end of the era of internal combustion engines. The top item on Germany’s foreign policy agenda, the further integration of the EU-member states into a powerful economic and political union, has for some years now given rise to daily crisis management, first caused by the financial crisis and, since last year, by the uncertainties of BREXIT. As if this was not enough, internal politics is still handling the social integration of more than a million refugees that entered the country in 2015, who rightly expect fair and just treatment, education, medical care and a future. It has been best practice to address such manifold issues with a strong and hands-on government, but – unfortunately – this is also currently missing. While the acting government is doing its best to handle the day-to-day tasks, one should not expect any bold move or strategic initiative before a stable, yet to be negotiated parliamentary coalition majority has installed new leadership, likely again under Angela Merkel. All that will drag well into 2018 and will not make life any easier. In stark contrast to the difficult situation the EU is facing in light of BREXIT, the single most impacting piece of regulation that will come into effect in May 2018 will be a European Regulation, the General Data Protection Regulation, which will harmonize data protection law across the EU and start a new era of data protection. Because of its broad scope and its extensive extraterritorial reach, combined with onerous penalties for non-compliance, it will open a new chapter in the way companies world-wide have to treat and process personal data. In all other areas of the law, we observe the continuation of a drive towards ever more transparency, whether through the introduction of new transparency registers disclosing relevant ultimate beneficial owner information or misconduct, through obligatory disclosure regimes (in the field of tax law), or through the automatic exchange under the OECD’s Common Reporting Standard of Information that hitherto fell under the protection of bank secrecy laws. While all these initiatives are well intentioned, they present formidable challenges for companies to comply with the increased complexity and adequately respond to the increased availability and flow of sensitive information. Even more powerful than the regulatory push is the combination of cyber-attacks, investigative journalism, and social media: within a heartbeat, companies or individuals may find themselves exposed on a global scale to severe allegations or fundamental challenges to the way they did or do business. While this trend is not of a legal nature, but a consequence of how we now communicate and whom we trust (or distrust), for those affected it may have immediate legal implications that are often highly complex and difficult to control and deal with. Interesting times usually are good times for lawyers that are determined to solve problems and tackle issues. This is what we love doing and what Gibson Dunn has done best time and again in the last 125 years. We therefore remain optimistic, even in view of the rough waters ahead which we and our clients will have to navigate. We want to thank you for your trust in our services in Germany and your business that we enjoy here and world-wide. We do hope that you will gain valuable insights from our Year-End Alert of legal developments in Germany that will help you to successfully focus and resource your projects and investments in Germany in 2018 and beyond; and we promise to be at your side if you need a partner to help you with sound and hands-on legal advice for your business in and with Germany or to help manage challenging or forward looking issues in the upcoming exciting times. ________________________________ Table of Contents 1.  Corporate, M&A 2.  Tax 3.  Financing and Restructuring 4.  Labor and Employment 5.  Real Estate 6.  Data Protection 7.  Compliance 8.  Antitrust and Merger Control ________________________________ 1. Corporate, M&A 1.1       Corporate, M&A – Transparency Register – New Transparency Obligations on Beneficial Ownership As part of the implementation of the 4th European Money Laundering Directive into German law, Germany has created a new central electronic register for information about the beneficial owners of legal persons organized under German private law as well as registered partnerships incorporated within Germany. Under the restated German Money Laundering Act (Geldwäschegesetz – GWG) which took effect on June 26, 2017, legal persons of German private law (e.g. capital corporations like stock corporations (AG) or limited liability companies (GmbH), registered associations (eingetragener Verein – e.V.), incorporated foundations (rechtsfähige Stiftungen)) and all registered partnerships (e.g. offene Handelsgesellschaft (OHG), Kommanditgesellschaft (KG) and GmbH & Co. KG) are now obliged to “obtain, keep on record and keep up to date” certain information about their “beneficial owners” (namely: first and last name, date of birth, place of residence and details of the beneficial interest) and to file the respective information with the transparency register without undue delay (section 20 (1) GWG). A “beneficial owner“ in this sense is a natural person who directly or indirectly holds or controls more than 25% of the capital or voting rights, or exercises control in a similar way (section 3 (2) GWG). Special rules apply for registered associations, trusts, non-charitable unregulated associations and similar legal arrangements. “Obtaining” the information does not require the entities to carry out extensive investigations, potentially through multi-national and multi-level chains of companies. It suffices to diligently review the information on record and to have in place appropriate internal structures to enable it to make a required filing without undue delay. The duty to keep the information up to date generally requires that the company checks at least on an annual basis whether there have been any changes in their beneficial owners and files an update, if necessary. A filing to the transparency register, however, is not required if the relevant information on the beneficial owner(s) is already contained in certain electronic registers (e.g. the commercial register or the so-called “Unternehmensregister“). This exemption only applies if all relevant data about the beneficial owners is included in the respective documents and the respective registers are still up to date. This essentially requires the obliged entities to diligently review the information available in the respective electronic registers. Furthermore, as a matter of principle, companies listed on a regulated market in the European Union (“EU“) or the European Economic Area (“EEA“) (excluding listings on unregulated markets such as e.g. the Entry Standard of the Frankfurt Stock Exchange) or on a stock exchange with equivalent transparency obligations with respect to voting rights are never required to make any filings to the transparency register. In order to enable the relevant entity to comply with its obligations, shareholders who qualify as beneficial owners or who are directly controlled by a beneficial owner, irrespective of their place of residence, must provide the relevant entity with the relevant information. If a direct shareholder is only indirectly controlled by a beneficial owner, the beneficial owner himself (and not the direct shareholder) must inform the company and provide it with the necessary information (section 20 (3) sentence 4 GWG). Non-compliance with these filing and information obligations may result in administrative fines of up to EUR 100,000. Serious, repeated or systematic breaches may even trigger sanctions up to the higher fine threshold of EUR 1 million or twice the economic benefit of the breach. The information submitted to the transparency register is not generally freely accessible. There are staggered access rights with only certain public authorities, including the Financial Intelligence Unit, law enforcement and tax authorities, having full access rights. Persons subject to know-your-customer (“KYC“) obligations under the Money Laundering Act such as e.g. financial institutions are only given access to the extent the information is required for them to fulfil their own KYC obligations. Other persons or the general public may only gain access if they can demonstrate a legitimate interest in such information. Going forward, every entity subject to the Money Laundering Act should verify whether it is beneficially owned within the aforementioned sense, and, if so, make the respective filing to the transparency register unless the relevant information is already contained in a public electronic register. Furthermore, relevant entities should check (at least) annually whether the information on their beneficial owner(s) as filed with the transparency or other public register is still correct. Also, appropriate internal procedures need to be set up to ensure that any relevant information is received by a person in charge of making filings to the registers. Back to Top 1.2       Corporate, M&A – New CSR Disclosure Obligations for German Public Interest Companies  Effective for fiscal years commencing on or after January 1, 2017, large companies with more than 500 employees are required to include certain non-financial information regarding their management of social and environmental challenges in their annual reporting (“CSR Information“). The new corporate social responsibility reporting rules (“CSR Reporting Rules“) implement the European CSR Directive into German law and are intended to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourage companies to develop a responsible and sustainable approach to business. The CSR Reporting Rules apply to companies with a balance sheet sum in excess of EUR 20 million and an annual turnover in excess of EUR 40 million, whose securities (stock or bonds etc.) are listed on a regulated market in the EU or the EEA as well as large banks and large insurance companies. It is estimated that approximately 550 companies in Germany are covered. Exemptions apply to consolidated subsidiaries if the parent company publishes the CSR Information in the group reporting. The CSR Reporting Rules require the relevant companies to inform on the policies they implemented, the results of such policies and the business risks in relation to (i) environmental protection, (ii) treatment of employees, (iii) social responsibility, (iv) respect for human rights and (v) anti-corruption and bribery. In addition, listed stock corporations are also obliged to inform with regard to diversity on their company boards. If a company has not implemented any such policy, an explicit and justified disclosure is required (“comply or explain”). Companies must further include significant non-financial performance indicators and must also include information on the amounts reported in this respect in their financial statements. The CSR Information can either be included in the annual report or by way of a separate CSR report, to be published on the company’s website or together with its regular annual report with the German Federal Gazette (Bundesanzeiger). The CSR Reporting Rules will certainly increase the administrative burden placed on companies when preparing their annual reporting documentation. It remains to be seen if the new rules will actually meet the expectations of the European legislator and foster and create a more sustainable approach of large companies to doing business in the future . Back to Top 1.3       Corporate, M&A – Corporate Governance Code Refines Standards for Compliance, Transparency and Supervisory Board Composition Since its first publication in 2002, the German Corporate Governance Code (Deutscher Corporate Governance Kodex – DCGK) which contains standards for good and responsible governance for German listed companies, has been revised nearly annually. Even though the DCGK contains only soft law (“comply or explain”) framed in the form of recommendations and suggestions, its regular updates can serve as barometer for trends in the public discussion and sometimes are also a forerunner for more binding legislative measures in the near future. The main changes in the most recent revision of the DCGK in February 2017 deal with aspects of compliance, transparency and supervisory board composition. Compliance The general concept of “compliance” was introduced by the DCGK in 2007. In this respect, the recent revision of the DCGK brought along two noteworthy new aspects. On the one hand, the DCGK now stresses in its preamble that good governance and management does not only require compliance with the law and internal policies but also ethically sound and responsive behavior (the “reputable businessperson concept”). On the other hand, the DCGK now recommends the introduction of a compliance management system (“CMS“). In keeping with the common principle of individually tailored compliance management systems that take into account the company’s specific risk situation, the DCGK now recommends appropriate measures reflecting the company’s risk situation and disclosing the main features of the CMS publically, thus enabling investors to make an informed decision on whether the CMS meets their expectations. It is further expressly recommended to provide employees with the opportunity to blow the whistle and also suggested to open up such whistle-blowing programs to third parties. Supervisory Board In line with the ongoing international trend of focusing on supervisory board composition, the DCGK now also recommends that the supervisory board not only should determine concrete objectives for its composition, but also develop a tailored skills and expertise profile for the entire board and to disclose in the corporate governance report to which extent such benchmarks and targets have been implemented in practice. In addition, the significance of having sufficient independent members on the supervisory board is emphasized by a new recommendation pursuant to which the supervisory board should disclose the appropriate number of independent supervisory board members as well as the members which meet the “independence” criteria in the corporate governance report. In accordance with international best practice, it is now also recommended to provide CVs for candidates for the supervisory board including inter alia relevant knowledge, skills and experience and to publish this information on the company’s website. With regard to supervisory board transparency, the DCGK now also recommends that the chairman of the supervisory board should be prepared, within an appropriate framework, to discuss topics relevant to the supervisory board with investors (please see in this regard our 2016-Year-End Alert, section 1.2). These new 2017 recommendations further highlight the significance of compliance and the role of the supervisory board not only for legislators but also for investors and other stakeholders. As soon as the annual declarations of non-conformity (“comply or explain”) are published over the coming weeks and months, it will be possible to assess how well these new recommendations will be received as well as what responses there will be to the planned additional supervisory board transparency (including, in particular, by family-controlled companies with employee co-determination on the supervisory board). Back to Top 1.4       Corporate, M&A – Employee Co-Determination: No European Extension As set out in greater detail in past alerts (please see in this regard our 2016 Year-End Alert, section 1.3 with further references), the scope and geographic reach of the German co-determination rules (as set out in the German Co-Determination Act; Mitbestimmungsgesetz – MitbestG and in the One-Third-Participation Act; Drittelbeteiligungsgesetz – DrittelbG) were the subject of several ongoing court cases. This discussion has been put to rest in 2017 by a decision of the European Court of Justice (ECJ, C-566/15 – July 18, 2017) that held that German co-determination rules and their restriction to German-based employees as the numeric basis for the relevant employee thresholds and as populace entitled to vote for such co-determined supervisory boards do not infringe against EU law principles of anti-discrimination and freedom of movement. The judgment has been received positively by both German trade unions and corporate players because it preserves the existing German co-determination regime and its traditional, local values against what many commentators would have perceived to be an undue pan-Europeanization of the thresholds and the right to vote for such bodies. In particular, the judgment averts the risk that many supervisory boards would have had to be re-elected based on a pan-European rather than solely German employee base. Back to Top 1.5       Corporate, M&A – Germany Tightens Rules on Foreign Takeovers On July 18, 2017, the amended provisions on foreign direct investments under the Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung – AWV), expanding and specifying the right of the Federal Ministry for Economic Affairs and Energy (“Ministry“) to review whether the takeover of domestic companies by investors outside the EU or the European Free Trade Area poses a danger to the public order or security of the Federal Republic of Germany came into force. The amendment has the following five main effects which will have a considerable impact on the M&A practice: (i) (non-exclusive) standard categories of companies and industries which are relevant to the public order or security for cross-sector review are introduced, (ii) the stricter sector-specific rules for industries of essential security interest (such as defense and IT-security) are expanded and specified, (iii) there is a reporting requirement for all takeovers within the relevant categories, (iv) the time periods for the review process are extended, and (v) there are stricter and more specific restrictions to prevent possible circumventions. Under the new rules, a special review by the German government is possible in cases of foreign takeovers of domestic companies which operate particularly in the following sectors: (i) critical infrastructure amenities, such as the energy, IT and telecommunications, transport, health, water, food and finance/insurance sectors (to the extent they are very important for the functioning of the community), (ii) sector-specific software for the operation of these critical infrastructure amenities, (iii) telecom carriers and surveillance technology and equipment, (iv) cloud computing services and (v) telematics services and components. The stricter sector-specific rules for foreign takeovers within the defense and IT-security industry are also expanded and now also apply to the manufacturers of defense equipment for reconnaissance and support. Furthermore, the reporting requirement no longer applies only to transactions within the defense and IT-security sectors, but also to all foreign takeovers that fall within the newly introduced cross-sector standard categories described above. The time periods allowed for the Ministry to intervene have been extended throughout. In particular, if an application for a clearance certificate is filed, the clearance certificate will be deemed granted in the absence of a formal review two months following receipt of the application rather than one month as in the past, and the review periods are suspended if the Ministry conducts negotiations with the parties involved. Further, a review may be commenced until five years after the signing of the purchase agreement, which in practice will likely result in an increase of applications for a clearance certificate in order to obtain more transaction certainty. Finally, the new rules provide for stricter and more specific restrictions of possible circumventions by, for example, the use of so-called “front companies” domiciled in the EU or the European Free Trade Area and will trigger the Ministry’s right to review if there are indications that an improper structuring or evasive transaction was at least partly chosen to circumvent the review by the Ministry. Although the scope of the German government’s ability to intervene in M&A processes has been expanded where critical industries are concerned, it is not clear yet to what extent stronger interference or more prohibitions or restrictions will actually occur in practice. And even though the new law provides further guidance, there are still areas of legal uncertainty which can have an impact on valuations and third party financing unless a clearance certificate is obtained. Due to the suspension of the review period in the case of negotiations with the Ministry, the review procedure has, at least in theory, no firm time limit. As a result, the M&A advisory practice has to be prepared for a more time-consuming and onerous process for transactions in the critical industries and may thus be forced to allow for more time between signing and closing. In addition, appropriate termination clauses (and possibly break fees) must be considered for purposes of the share purchase agreement in case a prohibition or restriction of the transaction on the basis of the amended AWV cannot be excluded. Back to Top 2. Tax 2.1       Tax – Unconstitutionality of German Change-of-Control Rules Tax loss carry forwards are an important asset in every M&A transaction. Over the past ten years the German change-of-control rules, which limit the use of losses and loss carry forwards (“Losses“) of a German target company, have undergone fundamental legislative changes. The current change-of-control rules may now face another significant revision as – according to the German Federal Constitutional Court (Bundesverfassungsgericht – BVerfG) and the Lower Tax Court of Hamburg – the current tax regime of the change-of-control rules violates the constitution. Under the current change-of-control rules, Losses of a German corporation will be forfeited on a pro rata basis if within a period of five years more than 25% but not more than 50% of the shares in the German loss-making corporation are transferred (directly or indirectly) to a new shareholder or group of shareholders with aligned interests. If more than 50% are transferred, Losses will be forfeited in total. There are exceptions to this rule for certain intragroup restructurings, built-in gains and – since 2016 – for business continuations, especially in the venture capital industry. On March 29, 2017, the German Federal Constitutional Court ruled that the pro rata forfeiture of Losses (share transfer of more than 25% but not more than 50%) is not in line with the constitution. The BVerfG held that the provision leads to unequal treatment of companies. The aim of avoiding legal but undesired tax optimizations does not justify the broad and general scope of the provision. The BVerfG has asked the German legislator to amend the change-of-control rules retroactively for the period from January 1, 2008 until December 31, 2015 and bring them in line with the constitution. The legislative changes need to be finalized by December 31, 2018. Furthermore, in another case on August 29, 2017, the Lower Tax Court of Hamburg held that the change-of-control rules, which result in a full forfeiture of Losses after a transfer of more than 50% of the shares in a German corporation, are also incompatible with the constitution. The ruling is based on the 2008 wording of the change-of-control rules but the wording of these rules is similar to that of the current forfeiture rules. In view of the March 2017 ruling of the Federal Constitutional Court on the pro-rata forfeiture, the Lower Tax Court referred this case also to the Federal Constitutional Court to rule on this issue as well. If the Federal Constitutional Court decides in favor of the taxpayer the German tax legislator may completely revise the current tax loss limitation regime and limit its scope to, for example, abusive cases. A decision by the Federal Constitutional Court is expected in the course of 2018. Affected market participants are therefore well advised to closely monitor further developments and consider the impact of potential changes on past and future M&A deals with German entities. Appeals against tax assessments should be filed and stays of proceedings applied for by reference to the case before the Federal Constitutional Court in order to benefit from a potential retroactive amendment of the change-of-control rules. Back to Top 2.2       Tax – New German Tax Disclosure Rules for Tax Planning Schemes In light of the Panama and Paradise leaks, the respective Finance Ministers of the German federal states (Bundesländer) created a working group in November 2017 to establish how the new EU Disclosure Rules for advisers and taxpayers as published by the European Commission (“Commission“) on July 25, 2017 can be implemented into German law. Within the member states of the EU, mandatory tax disclosure rules for tax planning schemes already exist in the UK, Ireland and Portugal. Under the new EU disclosure rules certain tax planners and advisers (intermediaries) or certain tax payers themselves must disclose potentially aggressive cross-border tax planning arrangements to the tax authorities in their jurisdiction. This new requirement is a result of the disclosure rules as proposed by the OECD in its Base Erosion and Profit Shifting (BEPS) Action 12 report, among others. The proposal requires tax authorities in the EU to automatically exchange reported information with other tax authorities in the EU. Pursuant to the Commission’s proposal, an “intermediary” is the party responsible for designing, marketing, organizing or managing the implementation of a tax payer´s reportable cross border arrangement, while also providing that taxpayer with tax related services. If there is no intermediary, the proposal requires the taxpayer to report the arrangement directly. This is, for example, the case if the taxpayer designs and implements an arrangement in-house, if the intermediary in question does not have a presence within the EU or in case the intermediary cannot disclose the information because of legal professional privilege. The proposal does not define what “arrangement” or “aggressive” tax planning means but lists characteristics (so-called “hallmarks“) of cross-border tax planning schemes that would strongly indicate whether tax avoidance or abuse occurred. These hallmarks can either be generic or specific. Generic hallmarks include arrangements where the tax payer has complied with a confidentiality provision not to disclose how the arrangement could secure a tax advantage or where the intermediary is entitled to receive a fee with reference to the amount of the tax advantage derived from the arrangement. Specific hallmarks include arrangements that create hybrid mismatches or involve deductible cross border payments between related parties with a preferential tax regime in the recipient’s tax resident jurisdiction. The information to be exchanged includes the identities of the tax payer and the intermediary, details about the hallmarks, the date of the arrangement, the value of the transactions and the EU member states involved. The implementation of such mandatory disclosure rules on tax planning schemes are heavily discussed in Germany especially among the respective bar associations. Elements of the Commission’s proposal are regarded as a disproportionate burden for intermediaries and taxpayers in relation to the objective. Further clarity is needed to align the proposal with the general principle of legal certainty. Certain elements of the proposal may contravene EU law or even the German constitution. And the interaction with the duty of professional secrecy for lawyers and tax advisors is also still unclear. Major efforts are therefore needed for the German legislator to make such a disclosure regime workable both for taxpayers/intermediaries and the tax administrations. It remains to be seen how the Commission proposal will be implemented into German law in 2018 and how tax structuring will be affected. Back to Top 2.3       Tax – Voluntary Self-Disclosure to German Tax Authorities Becomes More Challenging German tax law allows voluntary self-disclosure to correct or supplement an incorrect or incomplete tax return. Valid self-disclosure precludes criminal liability for tax evasion. Such exemption from criminal prosecution, however, does not apply if the tax evasion has already been “detected” at the time of the self-disclosure and this is at least foreseeable for the tax payer. On May 5, 2017 the German Federal Supreme Court (Bundesgerichtshof – BGH) further specified the criteria for voluntary self-disclosure to secure an exemption from criminal prosecution (BGH, 1 StR 265/16 – May 9, 2017). The BGH ruled that exemption from criminal liability might not apply if a foreign authority had already discovered the non- or underreported tax amounts prior to such self-disclosure. Underlying the decision of the BGH was the case of a German employee of a German defense company, who had received payments from a Greek business partner, but declared neither the received payments nor the resulting income in his tax declaration. The payment was a reward for his contribution in selling weapons to the Greek government. The Greek authorities learned of the payment to the German employee early in 2004 in the course of an anti-bribery investigation and obtained account statements proving the payment through intermediary companies and foreign banks. On January 6, 2014, the German employee filed a voluntary self-disclosure to the German tax authorities declaring the previously omitted payments. The respective German tax authority found that this self-disclosure was not submitted in time to exempt the employee from criminal liability. The issue in this case was by whom and at what moment in time the tax evasion needed to be detected in order to render self-disclosure invalid. The BGH ruled that the voluntary self-disclosure by the German employee was futile due to the fact that the payment at issue had already been detected by the Greek authorities at the time of the self-disclosure. In this context, the BGH emphasized that it was not necessary for the competent tax authorities to have detected the tax evasion, but it was sufficient if any other authority was aware of the tax evasion. The BGH made clear that this included foreign authorities. Thus, a prior detection is relevant if on the basis of a preliminary assessment of the facts a conviction is ultimately likely to occur. This requirement is for example met if it can be expected that the foreign authority that detected the incorrect, incomplete or omitted fact will forward this information to the German tax authorities as in the case before the BGH. In particular, there was an international assistance procedure in place between German and Greek tax authorities and the way the payments were made by using intermediaries and foreign banks made it obvious to the Greek authorities that the relevant amounts had not been declared in Germany. Due to the media coverage of the case, this was also at least foreseeable for the German employee. This case is yet another cautionary tale for tax payers not to underestimate the effects of increased international cooperation of tax authorities. Back to Top 3. Financing and Restructuring 3.1       Financing and Restructuring – Upfront Banking Fees Held Void by German Federal Supreme Court On July 4, 2017, the German Federal Supreme Court (Bundesgerichtshof – BGH) handed down two important rulings on the permissibility of upfront banking fees in German law governed loan agreements. According to the BGH, boilerplate clauses imposing handling, processing or arrangement fees on borrowers are void if included in standard terms and conditions (Allgemeine Geschäftsbedingungen). With this case, the court extended its prior rulings on consumer loans to commercial loans. The BGH argued that clauses imposing a bank’s upfront fee on a borrower fundamentally contradict the German statutory law concept that the consideration for granting a loan is the payment of interest. If ancillary pricing arrangements (Preisnebenabreden) pass further costs and expenses on to the borrower, the borrower is unreasonably disadvantaged by the user (Verwender) of standard business terms, unless the additional consideration is agreed for specific services that go beyond the mere granting of the loan and the handling, processing or arrangement thereof. In the cases at hand, the borrowers were thus awarded repayment of the relevant fee. The implications of these rulings for the German loan market are far-reaching. The rulings affect all types of upfront fees for a lender’s services which are routinely passed on to borrowers even though they would otherwise be owed by the lender pursuant to statutory law, a regulatory regime or under a contract or which are conducted in the lender’s own interest. Consequently, this covers fees imposed on the borrower for the risk assessment (Bonitätsprüfung), the valuation of collateral, expenses for the collection of information on the assessment of a borrower’s financing requirements and the like. At this stage, it is not yet certain if, for example, agency fees or syndication fees could also be covered by the decision. There are, however, good arguments to reason that services rendered in connection with a syndication are not otherwise legally or contractually owed by a lender. Upfront fees paid in the past, i.e. in 2015 or later, can be reclaimed by borrowers. The BGH applied the general statutory three year limitation period and argued that the limitation period commenced at the end of 2011 after Higher District Courts (Oberlandesgerichte) had held upfront banking fees void in deviation from previous rulings. As of such time, borrowers should have been aware that a repayment claim of such fees was possible and could have filed a court action even though the enforcement of the repayment was not risk-free. Going forward, it can be expected that lenders will need to modify their approach as a result of the rulings: Choosing a foreign (i.e. non-German) law for a separate fee agreement could be an option for lenders, at least, if either the lender or the borrower is domiciled in the relevant jurisdiction or if there is a certain other connection to the jurisdiction of the chosen law. If the loan is granted by a German lender to a German borrower, the choice of foreign law would also be generally recognized, but under EU conflict of law provisions mandatory domestic law (such as the German law on standard terms) would likely still continue to apply. In response to the ruling, lenders are also currently considering alternative fee structures: Firstly, the relevant costs and expenses underlying such fees are being factored into the calculation of the interest and the borrower is then given the option to choose an upfront fee or a (higher) margin. This may, however, not always turn out to be practical, in particular given that a loan may be refinanced prior to generating the equivalent interest income. Secondly, a fee could be agreed in a separate fee letter which specifically sets out services which go beyond the typical services a bank renders in its own interest. It may, however be difficult to determine services which actually justify a fee. Finally, a lender might charge typical upfront fees following genuine individual negotiations. This requires that the lender not only shows that it was willing to negotiate the amount of the relevant fee, but also that it was generally willing to forego the typical upfront fee entirely. However, if the borrower rejects the upfront fee, the lender still needs to rely on alternative fee arrangements. Further elaboration by the courts and market practice should be closely monitored by lenders and borrowers alike. Back to Top 3.2       Financing and Restructuring – Lingering Uncertainty about Tax Relief for Restructuring Profits Ever since the German Federal Ministry of Finance issued an administrative order in 2003 (“Restructuring Order“) the restructuring of distressed companies has benefited from tax relief for income tax on “restructuring profits”. In Germany, restructuring profits arise as a consequence of debt to equity swaps or debt waivers with regard to the portion of such debt that is unsustainable. Debtors and creditors typically ensured the application of the Restructuring Order by way of a binding advance tax ruling by the tax authorities thus providing for legal certainty in distressed debt scenarios for the parties involved. However, in November 2016, the German Federal Tax Court (Bundesfinanzhof – BFH) put an end to such preferential treatment of restructuring profits. The BFH held the Restructuring Order to be void arguing that the Federal Ministry of Finance had lacked the authority to issue the Restructuring Order. It held that such a measure would need to be adopted by the German legislator instead. The Ministry of Finance and the German restructuring market reacted with concern. As an immediate response to the ruling the Ministry of Finance issued a further order on April 27, 2017 (“Continuation Order”) to the effect that the Restructuring Order continued to apply in all cases in which creditors finally and with binding effect waived claims on or before February 8, 2017 (the date on which the ruling of the Federal Tax Court was published). But the battle continued. In August 2017, the Federal Tax Court also set aside this order for lack of authority by the Federal Ministry of Finance. In the meantime, the German Bundestag and the Bundesrat have passed legislation on tax relief for restructuring profits, but the German tax relief legislation will only enter into force once the European Commission issues a certificate of non-objection confirming the new German statutory tax relief’s compliance with EU restrictions on state aid. This leaves uncertainty as to whether the new law will enter into force in its current wording and when. Also, the new legislation will only cover debt waivers/restructuring profits arising after February 8, 2017 but at this stage does not provide for the treatment of cases before such time. In the absence of the 2003 Restructuring Order and the 2017 Continuation Order, tax relief would only be possible on the basis of equitable relief in exceptional circumstances. It appears obvious that no reliable restructuring concept can be based on potential equitable relief. Thus, it is advisable to look out for alternative structuring options in the interim: Subordination of debt: while this may eliminate an insolvency filing requirement for illiquidity or over indebtedness, the debt continues to exist. This may make it difficult for the debtor to obtain financing in the future. In certain circumstances, a carve-out of the assets together with a sustainable portion of the debt into a new vehicle while leaving behind and subordinating the remainder of the unsustainable portion of the debt, could be a feasible option. As the debt subsists, a silent liquidation of the debtor may not be possible considering the lingering tax burden on restructuring profits. Also, any such carve-out measures by which the debtor is stripped of assets may be challenged in case of a later insolvency of the debtor. A debt hive up without recourse may be a possible option, but a shareholder or its affiliates are not always willing to assume the debt. Also, as tax authorities have not issued any guidelines on the tax treatment of debt hive ups, a binding advance tax ruling from the tax authorities should be obtained before the debt hive up is executed. Still, a debt hive up could be an option if the replacement debtor is domiciled in a jurisdiction which does not impose detrimental tax consequences on the waiver of unsustainable debt. Converting the debt into a hybrid instrument which constitutes debt for German tax purposes and equity from a German GAAP perspective is no longer feasible. Pursuant to a tax decree from May 2016, the tax authorities argue that the creation of a hybrid instrument amounts to a taxable waiver of debt on the basis that tax accounting follows commercial accounting. It follows that irrespective of potential alternative structures which may suit a specific set of facts and circumstances, restructuring transactions in Germany continue to be challenging pending the entry into force of the new tax relief legislation. Back to Top 4. Labor and Employment 4.1       Labor and Employment – Defined Contribution Schemes Now Allowed In an effort to promote company pension schemes and to allow more flexible investments, the German Company Pension Act (Betriebsrentengesetz – BetrAVG) was amended considerably with effect as of January 1, 2018. The most salient novelty is the introduction of a purely defined contribution pension scheme, which had not been permitted in the past. Until now, the employer would always be ultimately liable for any kind of company pension scheme irrespective of the vehicle it was administered through. This is no longer the case with the newly introduced defined contribution scheme. The defined contribution scheme also entails considerable other easements for employers, e.g. pension adjustment obligations or the requirement of insolvency insurance no longer apply. As a consequence, a company offering a defined contribution pension scheme does not have to deal with the intricacies of providing a suitable investment to fulfil its pension promise, but will have met its duty in relation to the pension simply by paying the promised contribution (“pay and forget”). However, the introduction of such defined contribution schemes requires a legal basis either in a collective bargaining agreement (with a trade union) or in a works council agreement, if the union agreement so allows. If these requirements are met though, the new legal situation brings relief not only for employers offering company pension schemes but also for potential investors into German businesses for whom the German-specific defined benefit schemes have always been a great burden. Back to Top 4.2     Labor and Employment – Federal Labor Court Facilitates Compliance Investigations In a decision much acclaimed by the business community, the German Federal Labor Court (Bundesarbeitsgericht – BAG) held that intrusive investigative measures by companies against their employees do not necessarily require a suspicion of a criminal act by an employee; rather, less severe forms of misconduct can also trigger compliance investigations against employees (BAG, 2 AZR 597/16 – June 29, 2017). In the case at hand, an employee had taken sick leave, but during his sick leave proceeded to work for the company owned by his sons who happened to be competing against his current employer. After customers had dropped corresponding hints, the company assigned a detective to ascertain the employee’s violation of his contractual duties and subsequently fired the employee based on the detective’s findings. In the dismissal protection trial, the employee argued that German law only allowed such intrusive investigation measures if criminal acts were suspected. This restriction was, however, rejected by the BAG. This judgment ends a heated debate about the permissibility of internal investigation measures in the case of compliance violations. However, employers should always adhere to a last-resort principle when investigating possible violations. For instance, employees must not be seamlessly monitored at their workplace by way of a so-called “key logger” as the Federal Labor Court held in a different decision (BAG, 2 AZR 681/16 – July 27, 2017). Also, employers should keep in mind a recent ruling of the European Court of Human Rights of September 5, 2017 (ECHR, 61496/08). Accordingly, the workforce should be informed in advance that and how their email correspondence at the workplace can be monitored. Back to Top 5. Real Estate Real Estate – Invalidity of Written Form Remediation Clauses for Long-term Lease Agreements On September 27, 2017, the German Federal Supreme Court (Bundesgerichtshof – BGH) ruled that so-called “written form remediation clauses” (Schriftformheilungsklauseln) in lease agreements are invalid because they are incompatible with the mandatory provisions of section 550 of the German Civil Code (Bürgerliches Gesetzbuch – BGB; BGH, XII ZR 114/16 – September 27, 2017). The written form for lease agreements requires that all material agreements concerning the lease, in particular the lease term, identification of the leased premises and the rent amount, must be made in writing. If a lease agreement entered into for a period of more than one year does not comply with this written form requirement, mandatory German law allows either lease party to terminate the lease agreement with the statutory notice period irrespective of whether or not a fixed lease term was agreed upon. The statutory notice period for commercial lease agreements is six months (less three business days) to the end of any calendar quarter. To avoid the risk of termination for non-compliance with the written form requirement, German commercial lease agreements regularly contain a general written form remediation clause. Pursuant to such clause, the parties of the lease agreement undertake to remediate any defect in the written form upon request of one of the parties. While such general written form remediation clauses were upheld in several decisions by various Higher District Courts (Oberlandesgerichte) in the past, the BGH had already rejected the validity of such clauses vis-à-vis the purchasers of real property in 2014. With this new decision, the BGH has gone one step further and denied the validity of general written form remediation clauses altogether. Only in exceptional circumstances, the lease parties are not entitled to invoke the non-compliance with the written form requirement on account of a breach of the good faith principle. Such exceptional circumstances may exist, for example, if the other party faced insolvency if the lease were terminated early as a result of the non-compliance or if the lease parties had agreed in the lease agreement to remediate such specific written form defect. This new decision of the BGH forces the parties to long-term commercial lease agreements to put even greater emphasis on ensuring that their lease agreements comply with the written form requirement at all times because remediation clauses as potential second lines of defense no longer apply. Likewise, the due diligence process of German real estate transactions will have to focus even more on the compliance of lease agreements with the written form requirement. Back to Top 6.  Data Protection Data Protection – Employee Data Protection Under New EU Regulation After a two-year transition period, the EU General Data Protection Regulation (“GDPR“) will enter into force on May 25, 2018. The GDPR has several implications for data protection law covering German employees, which is already very strictly regulated. For example, under the GDPR any handling of personnel data by the employer requires a legal basis. In addition to statutory laws or collective agreements, another possible legal basis is the employee’s explicit written consent. The transfer of personnel data to a country outside of the European Union (“EU“) will have to comply with the requirements prescribed by the GDPR. If the target country has not been regarded as having an adequate data protection level by the EU Commission, additional safeguards will be required to protect the personnel data upon transfer outside of the EU. Otherwise, a data transfer is generally not permitted. The most threatening consequence of the GDPR is the introduction of a new sanctions regime. It now allows fines against companies of up to 4% of the entire group’s revenue worldwide. Consequently, these new features, especially the drastic new sanction regime, call for assessments of, and adequate changes to, existing compliance management systems with regard to data protection issues. Back to Top 7. Compliance 7.1       Compliance – Misalignment of International Sanction Regimes Requires Enhanced Attention to the EU Blocking Regulation and the German Anti-Boycott Provisions The Trump administration has been very active in broadening the scope and reach of the U.S. sanctions regime, most recently with the implementation of “Countering America’s Adversaries Through Sanctions Act (H.R. 3364) (‘CAATSA‘)” on August 2, 2017 and the guidance documents that followed. CAATSA includes significant new law codifying and expanding U.S. sanctions on Russia, North Korea, and Iran. The European Union (“EU“) has not followed suit. More so, the EU and European leaders openly stated their frustration about both a perceived lack of consultation during the process and the substance of the new U.S. sanctions. Specifically, the EU and European leaders are concerned about the fact that CAATSA authorizes secondary sanctions on any person supporting a range of activities. Among these are the development of Russian energy export pipeline projects, certain transactions with the Russian intelligence or defense sectors or investing in or otherwise facilitating privatizations of Russia’s state-owned assets that unjustly benefits Russian officials or their close associates or family members. The U.S. sanctions regime differentiates between primary sanctions that apply to U.S. persons (U.S. citizens, permanent U.S. residents and companies under U.S. jurisdiction) and U.S. origin goods, and secondary sanctions that expand the reach of U.S. sanctions by penalizing non-U.S. persons for their involvement in certain targeted activities. Secondary sanctions can take many forms but generally operate by restricting or threatening to restrict non-U.S. person access to the U.S. market, including its global financial institutions. European, especially export-heavy and internationally operating German companies are thus facing a dilemma. While they have to fear possible U.S. secondary sanctions for not complying with U.S. regulations, potential penalties also loom from European member state authorities when doing so. These problems are grounded in European and German legislation aimed at protecting from and counteracting financial and economic sanctions issued by countries outside of the EU and Germany, unless such sanctions are themselves authorized under relevant UN, European, and German sanctions legislation. On the European level, Council Regulation (EC) No 2271/96 of November, 22 1996 as amended (“EU Blocking Regulation“) is aimed at protecting European persons against the effects of the extra-territorial application of laws, such as certain U.S. sanctions directed at Cuba, Iran and Libya. Furthermore, it also aims to counteract the effects of the extra-territorial application of such sanctions by prohibiting European persons from complying with any requirement or prohibition, including requests of foreign courts, based on or resulting, directly or indirectly, from such U.S. sanctions. For companies subject to German jurisdiction, section 7 of the German Foreign Trade and Payments Ordinance (Außenwirtschaftsverordnung – AWV), states that “[t]he issuing of a declaration in foreign trade and payments transactions whereby a resident participates in a boycott against another country (boycott declaration) shall be prohibited” to the extent such a declaration would be contradictory to UN, EU and German policy. With the sanctions regime on the one hand and the blocking legislation at EU and German level on the other hand, committing to full compliance with U.S. sanctions whilst falling within German jurisdiction, could be deemed a violation of the AWV.  Violating the AWV can lead to fines by the German authorities and, under German civil law, might render a relevant contractual provision invalid. For companies conducting business transactions on a global scale, the developing non-alignment of U.S. and European / German sanctions requires special attention. Specifically, covenants with respect to compliance with U.S. or other non-EU sanctions should be reviewed and carefully drafted in light of the diverging developments of U.S. and other non-EU sanctions on the one hand and European / German sanctions on the other hand. Back to Top 7.2       Compliance – Restated (Anti-) Money Laundering Act – Significant New Requirements for the Non-Financial Sector and Good Traders On June 26, 2017, the restated German Money Laundering Act (Geldwäschegesetz – GWG), which transposes the 4th European Anti-Money Laundering Directive (Directive (EU 2015/849 of the European Parliament and of the Council) into German law, became effective. While the scope of businesses that are required to conduct anti-money laundering procedures remains generally unchanged, the GWG introduced a number of new requirements, in particular for non-financial businesses, and significantly increases the sanctions for non-compliance with these obligations. The GWG now extends anti money laundering (“AML“) risk management concepts previously known from the financial sector also to non-financial businesses including good traders. As a matter of principle, all obliged businesses are now required to undertake a written risk analysis for their business and have in place internal risk management procedures proportionate to the type and scope of the business and the risks involved in order to effectively mitigate and manage the risks of money laundering and terrorist financing. In case the obliged business is the parent company of a group, a group-wide risk analysis and group-wide risk management procedures are required covering subsidiaries worldwide who also engage in relevant businesses. The risk analysis must be reviewed regularly, updated if required and submitted to the supervisory authority upon request. Internal risk management procedures include, in particular, client due diligence (“know-your customer”), which requires the identification and verification of customers, persons acting on behalf of customers as well as of beneficial owners of the customer (see also section 1.1 above on the Transparency Register). In addition, staff must be monitored for their reliability and trained regularly on methods and types of money laundering and terrorist financing and the applicable legal obligations under the GWG as well as data protection law, and whistle-blowing systems must be implemented. Furthermore, businesses of the financial and insurance sector as well as providers of gambling services must appoint a money laundering officer (“MLO“) at senior management level as well as a deputy, who are responsible for ensuring compliance with AML rules. Other businesses may also be ordered by their supervisory authority to appoint a MLO and a deputy. Good traders including conventional industrial companies are subject to the AML requirements under the GWG, irrespective of the type of goods they are trading in. However, some of the requirements either do not apply or are significantly eased. Good traders must only conduct a risk analysis and have in place internal AML risk management procedures if they accept or make (!) cash payments of EUR 10,000 or more. Furthermore, client due diligence is only required with respect to transactions in which they make or accept cash payments of EUR 10,000 or more, or in case there is a suspicion of money laundering or terrorist financing. Suspicious transactions must be reported to the Financial Intelligence Unit (“FIU“) without undue delay. As a result, also low cash or cash free good traders are well advised to train their staff to enable them to detect suspicious transactions and to have in place appropriate documentation and reporting lines to make sure that suspicious transactions are filed with the FIU. Non-compliance with the GWG obligations can be punished with administrative fines of up to EUR 100,000. Serious, repeated or systematic breaches may even trigger sanctions up to the higher fine threshold of EUR 1 million or twice the economic benefit of the breach. For the financial sector, even higher fines of up to the higher of EUR 5 million or 10% of the total annual turnover are possible. Furthermore, offenders will be published with their names by relevant supervisory authorities (“naming and shaming”). Relevant non-financial businesses are thus well advised to review their existing AML compliance system in order to ensure that the new requirements are covered. For good traders prohibiting cash transactions of EUR 10,000 or more and implementing appropriate safeguards to ensure that the threshold is not circumvented by splitting a transaction into various smaller sums, is a first and vital step. Furthermore, holding companies businesses who mainly acquire and hold participations (e.g. certain private equity companies), must keep in mind that enterprises qualifying as “finance enterprise” within the meaning of section 1 (3) of the German Banking Act (Kreditwesengesetz – KWG) are subject to the GWG with no exemptions. Back to Top  7.3       Compliance – Protection of the Attorney Client Privilege in Germany Remains Unusual The constitutional complaint (Verfassungsbeschwerde) brought by Volkswagen AG’s external legal counsel requesting the return of work product prepared during the internal investigation for Volkswagen AG remains pending before the German Federal Constitutional Court (Bundesverfassungsgericht – BVerfG). The Munich public prosecutors had seized these documents in a dawn raid of the law firm’s offices. While the BVerfG has granted injunctive relief (BVerfG, 2 BvR 1287/17, 2 BvR 1583/17 – July 25, 2017) and ordered the authorities, pending a decision on the merits of the case, to refrain from reviewing the seized material, this case is a timely reminder that the concept of the attorney client privilege in Germany is very different to that in common law jurisdictions. In a nutshell: In-house lawyers do not enjoy legal privilege. Material that would otherwise be privileged can be seized on the client’s premises – with the exception of correspondence with and work product from / for criminal defense counsel. The German courts are divided on the question of whether corporate clients can already appoint criminal defense counsel as soon as they are concerned that they may be the target of a future criminal investigation, or only when they have been formally made the subject of such an investigation. Searches and seizures at a law firm, however, are a different matter. A couple of years ago, the German legislator changed the German Code of Criminal Procedure (Strafprozessordnung – StPO) to give attorneys in general, not only criminal defense counsel, more protection against investigative measures (section 160a StPO). Despite this legislation, the first and second instance judges involved in the matter decided in favor of the prosecutors. As noted above, the German Federal Constitutional Court has put an end to this, at least for now. According to the court, the complaints of the external legal counsel and its clients were not “obviously without any merits” and, therefore, needed to be considered in the proceedings on the merits of the case. In order not to moot these proceedings, the court ordered the prosecutors to desist from a review of the seized material, and put it under seal until a full decision on the merits is available. In the interim period, the interest of the external legal counsel and its clients to protect the privilege outweighed the public interest in a speedy criminal investigation. At this stage, it is unclear when and how the court will decide on the merits. Back to Top 7.4       Compliance – The European Public Prosecutor’s Office Will Be Established – Eventually After approximately four years of discussions, 20 out of the 28 EU member states agreed in June 2017 on the creation of a European Public Prosecutor’s Office (“EPPO“). In October, the relevant member states adopted the corresponding regulation (Regulation (EU) 2017/1939 – “Regulation“). The EPPO will be in charge of investigating, prosecuting and bringing to justice the perpetrators of offences against the EU’s financial interests. The EPPO is intended to be a decentralized authority, which operates via and on the basis of European Delegated Prosecutors located in each member state. The central office in Luxembourg will have a European Chief Prosecutor supported by 20 European Prosecutors, as well as technical and investigatory staff. While EU officials praise this Regulation as an “important step in European justice cooperation“, it remains to be seen whether this really is a measure which ensures that “criminals [who] act across borders […] are brought to justice and […] taxpayers’ money is recovered” (U. Reinsalu, Estonian Minister of Justice). It will take at least until 2020 until the EPPO is established, and criminals will certainly not restrict their activities to the territories of those 20 countries which will cooperate under the new authority (being: Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Estonia, Germany, Greece, Finland, France, Italy, Latvia, Lithuania, Luxembourg, Portugal, Romania, Slovenia, Slovakia and Spain). In addition, as the national sovereignty of the EU member states in judicial matters remains completely intact, the EPPO will not truly investigate “on the ground”, but mainly assume a coordinating role. Last but not least, its jurisdiction will be limited to “offences against the EU’s financial interests”, in particular criminal VAT evasion, subsidy fraud and corruption involving EU officials. A strong enforcement, at least prima facie, looks different. To end on a positive note, however: the new body is certainly an improvement on the status quo in which the local prosecutors from 28 member states often lack coordination and team spirit. Back to Top 7.5       Compliance – Court Allows for Reduced Fines in Compliance Defense Case The German Federal Supreme Court (Bundesgerichtshof – BGH) handed down a decision recognizing for the first time that a company’s implementation of a compliance management system (“CMS“) constitutes a mitigating factor for the assessment of fines imposed on such company where violations committed by its employees are imputed to the company (BGH 1 StR 265/16 – May 9, 2017). According to the BGH, not only the implementation of a compliance management system at the time of the detection of the offense should be considered, but the court may also take into account subsequent efforts of a company to enhance its respective internal processes that were found deficient. The BGH held that such remediation measures can be considered as a mitigating factor when assessing the amount of fines if they are deemed suitable to “substantially prevent an equivalent violation in the future.” The BGH’s ruling has finally clarified the highest German court’s views on a long-lasting discussion about whether establishing and maintaining a CMS may limit a company’s liability for legal infringements. The recognition of a company’s efforts to establish, maintain and improve an effective CMS should encourage companies to continue working on their compliance culture, processes and systems. Similarly, management’s efforts to establish, maintain and enhance a CMS, and conduct timely remediation measures, upon becoming aware of deficiencies in the CMS, may become relevant factors when assessing potential civil liability exposure of corporate executives pursuant to section. 43 German Limited Liability Companies Act (Gesetz betreffend Gesellschaften mit beschränkter Haftung – GmbHG) and section 93 (German Stock Companies Act (Aktiengesetz – AktG). Consequently, the implications of this landmark decision are important both for corporations and their senior executives. Back to Top 8.  Antitrust and Merger Control In 2017, the German Federal Cartel Office (Bundeskartellamt – BKartA) examined about 1,300 merger filings, imposed fines in the amount of approximately EUR 60 million on companies for cartel agreements and conducted several infringement proceedings. On June 9, 2017, the ninth amendment to the German Act against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen – GWB) came into force. The most important changes concern the implementation of the European Damages Directive (Directive 2014/104/EU of the European Parliament and of the Council of November, 26 2014), but a new merger control threshold was also introduced into law. Implementation of the European Damages Directive The amendment introduced various procedural facilitations for claimants in civil cartel damage proceedings. There is now a refutable presumption in favor of cartel victims that a cartel caused damage. However, the claimant still has the burden of proof regarding the often difficult to argue fact, if it was actually affected by the cartel and the amount of damages attributable to the infringement. The implemented passing-on defense allows indirect customer claimants to prove that they suffered damages from the cartel – even if not direct customers of the cartel members – because the intermediary was presumably able to pass on the cartel overcharge to his own customers (the claimants). The underlying refutable presumption that overcharges were passed on is not available in the relationship between the cartel member and its direct customer because the passing-on defense must not benefit the cartel members. In deviation from general principles of German civil procedural law, according to which each party has to produce the relevant evidence for the facts it relies on, the GWB amendment has significantly broadened the scope for requesting disclosure of documents. The right to request disclosure from the opposing party now to a certain degree resembles discovery proceedings in Anglo-American jurisdictions and has therefore also been referred to as “discovery light”. However, the documents still need to be identified as precisely as possible and the request must be reasonable, i.e., not place an undue burden on the opposing party. Documents can also be requested from third parties. Leniency applications and settlement documents are not captured by the disclosure provisions. Furthermore, certain exceptions to the principle of joint and several liability of cartelists for damage claims in relation to (i) internal regress against small and medium-sized enterprises, (ii) leniency applicants, and (iii) settlements between cartelists and claimants were implemented. In the latter case, non-settling cartelists may not recover contribution for the remaining claim from settling cartelists. Finally, the regular limitation period for antitrust damages claims has been extended from three to five years. Cartel Enforcement and Corporate Liability Parent companies can now also be held liable for their subsidiary’s anti-competitive conduct under the GWB even if they were not party to the infringement themselves. The crucial factor – comparable to existing European practice – is the exercise of decisive control. Furthermore, legal universal successors and economic successors of the infringer can also be held liable for cartel fines. This prevents companies from escaping cartel fines by restructuring their business. Publicity The Bundeskartellamt has further been assigned the duty to inform the public about decisions on cartel fines by publishing details about such decisions on its webpage. Taking into account recent efforts to establish a competition register for public procurement procedures, companies will face increased public attention for competition law infringements, which may result in infringers being barred from public or private contracting. Whistleblower Hotline Following the example of the Bundeskartellamt and other antitrust authorities, the European Commission (“Commission“) has implemented a whistleblowing mailbox. The IT-based system operated by an external service provider allows anonymous hints to or bilateral exchanges with the Commission – in particular to strengthen its cartel enforcement activities. The hope is that the whistleblower hotline will add to the Commission’s enforcement strengths and will balance out potentially decreasing leniency applications due to companies applying for leniency increasingly facing the risk of private cartel damage litigation once the cartel has been disclosed. Merger Control Thresholds To provide for control over transactions that do not meet the current thresholds but may nevertheless have significant impact on the domestic market (in particular in the digital economy), a “size of transaction test” was implemented; mergers with a purchase price or other consideration in excess of EUR 400 million now require approval by the Bundeskartellamt if at least two parties to the transaction achieve at least EUR 25 million and EUR 5 million in domestic turnover, respectively. Likewise, in Austria a similar threshold was established (EUR 200 million consideration plus a domestic turnover of at least EUR 15 million). The concept of ministerial approval (Ministererlaubnis), i.e., an extra-judicial instrument for the Minister of Economic Affairs to exceptionally approve mergers prohibited by the Bundeskartellamt, has been reformed by accelerating and substantiating the process. In May 2017, the Bundeskartellamt published guidance on remedies in merger control making the assessment of commitments more transparent. Remedies such as the acceptance of conditions (Bedingungen) and obligations (Auflagen) can facilitate clearance of a merger even if the merger actually fulfils the requirements for a prohibition. The English version of the guidance is available at: http://www.bundeskartellamt.de/SharedDocs/Publikation/EN/Leitlinien/Guidance%20on%20Remedies%20in%20Merger%20Control.html; jsessionid=5EA81D6D85D9FD8891765A5EA9C26E68.1_cid378?nn=3600108. Case Law Finally on January 26, 2017, there has been a noteworthy decision by the Higher District Court of Düsseldorf (OLG Düsseldorf, Az. V-4 Kart 4/15 OWI – January 26, 2017; not yet final): The court confirmed a decision of the Bundeskartellamt that had imposed fines on several sweets manufacturers for exchanging competitively sensitive information and even increased the fines. This case demonstrates the different approach taken by courts in calculating cartel fines based on the group turnover instead of revenues achieved in the German market. Back to Top     The following Gibson Dunn lawyers assisted in preparing this client update:  Birgit Friedl, Marcus Geiss, Jutta Otto, Silke Beiter, Peter Decker, Ferdinand Fromholzer, Daniel Gebauer, Kai Gesing, Franziska Gruber, Johanna Hauser, Maximilian Hoffmann, Markus Nauheim, Richard Roeder, Katharina Saulich, Martin Schmid, Sebastian Schoon, Benno Schwarz, Michael Walther, Finn Zeidler, Mark Zimmer and Caroline Ziser Smith. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. The two German offices of Gibson Dunn in Munich and Frankfurt bring together lawyers with extensive knowledge of corporate / M&A, financing, restructuring and bankruptcy, tax, labor, real estate, antitrust, intellectual property law and extensive compliance / white collar crime experience. The German offices are comprised of seasoned lawyers with a breadth of experience who have assisted clients in various industries and in jurisdictions around the world. Our German lawyers work closely with the firm’s practice groups in other jurisdictions to provide cutting-edge legal advice and guidance in the most complex transactions and legal matters. For further information, please contact the Gibson Dunn lawyer with whom you work or any of the following members of the German offices: General Corporate, Corporate Transactions and Capital Markets Lutz Englisch (+49 89 189 33 150), lenglisch@gibsondunn.com) Markus Nauheim (+49 89 189 33 122, mnauheim@gibsondunn.com) Ferdinand Fromholzer (+49 89 189 33 170, ffromholzer@gibsondunn.com) Dirk Oberbracht (+49 69 247 411 510, doberbracht@gibsondunn.com) Wilhelm Reinhardt (+49 69 247 411 520, wreinhardt@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Silke Beiter (+49 89 189 33 170, sbeiter@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Annekatrin Pelster (+49 69 247 411 521, apelster@gibsondunn.com) Finance, Restructuring and Insolvency Sebastian Schoon (+49 89 189 33 160, sschoon@gibsondunn.com) Birgit Friedl (+49 89 189 33 180, bfriedl@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Tax Hans Martin Schmid (+49 89 189 33 110, mschmid@gibsondunn.com) Labor Law Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Real Estate Peter Decker (+49 89 189 33 115, pdecker@gibsondunn.com) Daniel Gebauer (+ 49 89 189 33 115, dgebauer@gibsondunn.com) Technology Transactions / Intellectual Property / Data Privacy Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) Corporate Compliance / White Collar Matters Benno Schwarz (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Finn Zeidler (+49 69 247 411 530, fzeidler@gibsondunn.com) Antitrust and Merger Control Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP, 333 South Grand Avenue, Los Angeles, CA 90071 Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 24, 2017 |
International Investors to Be Liable to UK Tax on Capital Gains Derived from UK Real Estate from 2019

Background 1.1          The UK has the largest commercial property market in Europe, attracting over $31bn of investment in the first half of 2017 (even after the Brexit vote). International investors dominate in London, lured by big buildings with long leases to established businesses and a stable legal environment – international investors account for about 75% of investment in property in central-London. 1.2          The UK traditionally had not taxed international investors on capital gains derived from investment in UK land and buildings. As such, the UK has long been a favoured destination for international real estate investors who have, year after year, consistently invested billions of dollars, euros, and pounds into both commercial and residential schemes. As compared with its peers, the UK has always been viewed as one of the most favourable real estate markets on the globe. The landscape may be about to change. 1.3          It has always taxed rental income (although with a generous deduction allowed for interest costs incurred on acquisition finance). Since 2013, the UK has imposed taxation on international investors on gains derived from some residential UK property, and these provisions were broadened in 2015. 1.4          The UK Government announced in the Autumn 2017 Budget (22 November 2017) that tax will be charged on gains made by international investors on disposals of all types of UK land and buildings – residential and commercial, and whether held owned directly or indirectly. The proposed changes extend the existing rules that apply to residential property and are due to come into effect from April 2019. 1.5          The UK Government has published a consultation document (“Consultation Document”)[1]  on the implementation of the new taxation regime. The Consultation Document proposes that a single regime will be created for the disposal of interests in both residential and non-residential property. 1.6          The proposed rules are intended to apply not only to direct disposals of UK immovable property, but also to indirect disposals – in other words the sale of interests in entities whose value is derived from UK land and buildings. 1.7          Anti-forestalling measures will be introduced with effect from 22 November 2017 (being the day on which the announcement was made), to prevent circumvention of the tax through “treaty shopping”. Autumn Budget 2017 Consultation Document 2.1          The Consultation Document makes it clear that the UK Government’s policy is to amend the law with effect from April 2019 to bring non-UK residents within the charge to UK tax on disposals of all kinds of UK immoveable property, more closely aligning the tax treatment of non-UK residents with that of UK residents, and reducing the incentive for multinational groups to hold UK land and buildings through offshore structures. 2.2         The consultation being conducted relates to the implementation of this policy, not to its principle. In the current political climate in the UK, our view is that it is highly likely that the proposals in the Consultation Document will be implemented. Direct disposals 3.1          The UK Government intends that all gains accruing on disposals of interests in UK immovable property will become chargeable to UK tax with effect from April 2019. 3.2         Non-residents will be taxed on any gains made on the direct disposal of UK land and buildings. In addition, disposals by non-resident widely-held companies will be brought into charge to tax. 3.3         The rate of tax on any direct disposals will be the UK capital gains tax (subject to the move to corporation tax for corporate owners – see below). 3.4         Non-residential property already owned as at April 2019 will be re-based to its April 2019 value – with the intention that non-residential property will only be taxed to the extent of its appreciation in value after April 2019. 3.5         Gains arising on the disposal of residential property are already within the scope of UK tax, and the re-basing point for residential property will remain at April 2015. In cases of mixed-use property (where the property includes both residential and non-residential elements), or in the case of change of use (for example, the conversion of residential property to non-residential use, or vice versa in the period between April 2015 and April 2019), there will need to be an allocation of the gain between the different elements, using the different rebasing points. 3.6         The NRCGT regime currently excludes widely-held companies from the scope of tax. That exemption will be removed with effect from April 2019. 3.7         Gains will be computed in the same way as for UK resident investors. Any losses arising on the disposal of UK property will be available for offset against UK taxable gains. For companies within the scope of corporation tax, the losses will be treated in the same way as other capital gains and losses for corporation tax purposes. For other investors, capital losses will be available for offset against capital gains arising on the disposal of other UK property. 3.8         Owners who are exempt from UK tax, otherwise than because of their non-resident status (such as certain pension schemes or sovereign investors), will be exempt from the tax. 3.9         If the property owner has made an overall loss on a direct disposal of the property, but re-basing results in a taxable gain, there will be an option for the loss to be computed using the original acquisition cost. Indirect disposals 4.1          Disposals of significant interests in entities that own (directly or indirectly) interests in UK real estate will also be brought within the scope of UK tax. 4.2         The following tests must be met at the date of disposal in order for a tax charge to be imposed: 4.2.1      The entity being disposed must be “property rich”; and 4.2.2     The non-resident must hold a 25% or greater interest in the entity, or have held 25% or more at some point in the five years ending on that date 4.3         Property Rich:  An entity is “property rich”, if 75% or more of its gross asset value as at the time of the disposal is derived from UK immovable property. This includes any shareholding in a company deriving its value directly and indirectly from the UK property, any partnership interests, any interest in settled property as well as any option, consent or embargo affecting the disposition of the UK property. The test looks through layers of ownership to arrive at a just and reasonable attribution of value. The value of both residential and non-residential UK properties will count towards the 75%. However, the value of non-UK property will not count towards the 75%. 4.4         The property richness test is applied to the gross value of the entity’s assets, so liabilities such as acquisition finance are excluded in making the assessment. The test uses the market value of the assets of the entity at the time of the disposal. 4.5         If an entity is not property rich at the time the investor acquires his investment, but becomes property rich subsequently, the whole of the gain is within the scope of UK tax – not just the amount attributable to the period after the company becomes property rich (subject to April 2019 rebasing). Rebasing to April 2019 is the only calculation permitted for investments held prior to that date (the ability to use original acquisition cost is not permitted for indirect disposals). 4.6         25% Ownership:  The 25% ownership test is intended to exclude minority investors who may not necessarily be aware of the underlying asset mix of the entity, and who are unlikely to have control or influence over the entity’s activities. 4.7         In determining whether an owner has a 25% interest, the owner will need to look back over five years to see if the test was met at any time in the five-year period. In addition, holdings of related parties will also be taken into account in the determination. For these purposes, related parties will include persons who are “connected” (using the existing rules in the UK Corporation Tax Act) but also persons “acting together”, to include situations where persons come together with a common object in relation to a UK property owning entity. The “acting together” rules will be modelled on those in the UK’s corporate interest restriction provisions. 4.8         Although the tax charge will be limited to gains accruing after April 2019 (because of the re-basing), the “look back” would take account of holdings of the owner prior to April 2019 (if that falls within the 5 year look-back period). So an investor who currently owns 50% of a UK property investment company, but sells down to 24% before April 2019, would not avoid the new tax charge if she or he sold the remaining holding before 2024 (the tax charge would be limited to the appreciation of the value of the 24% stake, and would be re-based to April 2019 values). 4.9         Groups:  The property richness test will be applied to the totality of entities being sold in a transaction. So if an investor were to sell shares in a holding company which was not itself property-rich, but which owned entities that were, the 75% test would be satisfied if, taken together, the entities being sold met the 75% test. 4.10       Calculation of gain:  Gains will be calculated on the basis of the interest being sold, using the normal rules that apply to the disposal of shares (or other investments). Anti-avoidance provisions will apply in the same way as they would to UK resident taxpayers. Investors who are exempt from UK tax, otherwise than because of their non-resident status (such as certain pension schemes), will be exempt from the tax. 4.11        Substantial shareholder exemption:  The Finance (No 2) Act 2017 introduced changes to the substantial shareholder exemption (“SSE”) to extend the exemption to qualifying institutional investors. SSE will apply to disposals of property rich companies (or groups) by such investors. Residential property 5.1          The current NRCGT rules apply only to direct disposals, and do not apply to disposals by widely-held companies. 5.2         NRCGT will be amended so that it extends to widely-held companies, and also to bring indirect disposals within the scope of the tax. The exemption within NRCGT for life-assurance companies owning residential properties will also be removed. 5.3         Widely-held companies will use April 2019 as the NRCGT rebasing point for all property disposals (both residential and non-residential). Closely-held companies will continue to use April 2015 as the rebasing point for direct disposals of residential property (and will use April 2019 for disposals of non-residential property). 5.4         April 2019 will be the NRCGT rebasing point for all disposals of indirect interests. 5.5         The NRCGT rules will extend to widely held companies whereby any disposals of UK residential property will be charged to corporation tax. Non-resident close companies disposing of residential property will also be charged corporation tax instead of capital gains tax. 5.6         The UK Government is considering harmonising the existing regime for ATED-related gains with the wider proposals for taxing non-resident gains on UK immovable property, and one of the areas of consultation within the Consultation Document relates to the simplification and harmonisation of the ATED rules. Double Tax Treaties 6.1          It is generally accepted that the primary taxing rights over immoveable property (such as land and buildings) belongs to the state in which the immovable property is located. 6.2         As historically the UK has not exercised this right, it has not been concerned to ensure that this right is fully reflected in its double tax treaties. A number of treaties will require amendment to give the UK full taxing rights in relation to indirect disposals. In the meantime, the impact of a particular treaty may be to exempt from UK tax a disposal of an indirect interest in UK land and buildings – this is subject to the anti-forestalling provisions described below. 6.3         All of the UK’s double tax treaties include a provision allowing the UK to impose tax on a direct disposal of UK immoveable property. 6.4         Most (but not all) of the UK’s tax treaties include a “securitised land” provision, which allows the UK to impose tax on gains on the disposal of interests in entities that are UK-property rich. 6.5         But some older treaties do not include a securitised land provision, and these allocate taxing rights on the disposal of interests in a UK-property rich entity to the country of residence of the investor, and not the UK. Even where a treaty includes a securitised land provision, some apply only to shares in companies, and not to interests in other entities (such as partnerships or unit trusts), and in some of the treaties, the securitised land provisions apply only to the disposal by the investor of the interest it holds in the entity, and would not apply to disposals by underlying entities. In these cases, the UK’s taxing rights will be limited. 6.6         In cases where no tax treaty exists, the UK will be able to apply the indirect disposal charge without constraint. 6.7         Where a doubt tax treaty does exist, but does not allow the UK to tax indirect disposals without constraint, the UK government has announced its intention to negotiate with the other state to amend the treaty. Subject to the anti-forestalling provisions, if a non-resident investor disposes of his interest in a UK-property rich entity prior to the amendment taking effect, then the investor may be able to benefit from any exemption from UK tax in the treaty. 6.8         However, an anti-forestalling rule will apply to prevent investors from being able to reorganise their affairs in order to take advantage of a treaty exemption to which they are not already entitled. The anti-forestalling rule will apply to any arrangements entered into or after 22 November 2017 with the intention of obtaining a tax advantage relating to these new tax provisions through the operation of the provisions of a double tax treaty exemption. In these circumstances, HMRC will have the power to counteract the tax advantage by means of a tax assessment or the disallowance of a claim. Collective Investment Vehicles 7.1          UK REITs:  The profits and gains of the property rental business of a UK REIT are exempt from tax, and there is no intention to change this rule. A UK REIT is required to distribute at least 90% of its rental income by way of dividend, which is then taxed in the hands of its shareholders. There is no requirement for a UK REIT to distribute capital gains, but if those gains are distributed by way of dividend, those dividends will also be taxable in the hands of shareholders. 7.2         Currently UK residents shareholders are taxed on gains realised on the disposal of shares in a UK REIT, whereas non-resident shareholders are not. Under the new rules, if a UK REIT satisfies the property richness test, then a non-resident disposing of shares in the UK REIT will be within the scope of UK tax (if the non-resident has a 25% or greater interest in the REIT at the time of disposal or in the prior 5 years). 7.3         The intention is that a similar analysis would apply to other UK collective investment vehicles (such as property authorised investment funds and exempt unauthorised unit trusts), and the vehicle itself would not be liable to tax on the direct disposal of UK property. However, a non-resident investor would be liable to UK tax on a disposal of its investment in the vehicle (assuming the vehicle was “property rich” and the investor’s interest exceeded 25% (at the time of disposal or in the prior five years). 7.4         Overseas collective investment vehicles: Some funds are outside the scope of UK tax on capital gains only because of their non-resident status. This will change with the new rules. Direct disposals by such collective vehicles will come within the scope of UK tax with effect from April 2019. And from that same date, disposals by investors of their interests in such vehicles will also become taxable (assuming the vehicle was “property rich” and the investor’s interest exceeded 25% (at the time of disposal or in the prior five years). Corporation tax 8.1          In March 2017, the UK Government published its consultation on “Non-resident companies chargeable to Income Tax and Non-resident CGT”, which sought views on bringing closely held companies that own UK property within the scope of UK corporation tax. 8.2         A response to that consultation is expected to be published shortly, but the indication is that non-UK resident companies that own UK property will be brought within the scope of UK corporation tax as regards their UK property business. 8.3         The move to the corporation tax regime will have the effect of reducing the headline tax rate for such companies. The Government has announced that the main corporation tax rate will be 19% for the financial years 2018 and 2019, and will reduce to 17% for the financial year 2020. 8.4         In addition, the regime for tax reliefs for financing costs is somewhat more flexible under corporation tax rules than under income tax rules, and technical issues that can arise when a property is refinanced should no longer apply. 8.5         However, companies within the scope of corporation tax are subject to interest restrictions (broadly 30% of consolidated “tax EBITDA” with a de minimis of £2 million), and to the ability to carry-forward losses. There are limited exceptions for public infrastructure projects. These rules are complicated and outside the scope of this alert as are the application of the hybrid entity rules and the carry-forward loss limitations, which will also become applicable. Administration and compliance 9.1          Non-resident direct owners of UK property are already within the scope of UK tax (at least as regards rental income) and will be filing UK tax returns in respect of rental income under the Non-Resident Landlord Scheme. However, investors in property-rich entities will not be used to filing UK tax returns. 9.2         HMRC anticipate that most persons within the scope of the new charge will be aware of their obligations to file UK tax returns and pay UK tax, and will be compliant. But in order to ensure that HMRC are aware of transactions, reporting obligations will be imposed on professional advisors, as described below. 9.3         Under the current NRCGT 9.3 regime, a transaction must be reported by the seller to HMRC electronically within 30 days of completion. If the seller is already within the self-assessment regime, they may defer payment of the tax until the tax is due under the normal reporting process. Otherwise, they must pay within 30 days. The same process will apply to the new charge for investors who are not within the scope of corporation tax. This will apply to direct and indirect disposals, and for residential and non-residential properties. 9.4         For companies within the charge to corporation tax, they will be required to register for self-assessment with HMRC, and return (and pay) any tax within the normal corporation tax self-assessment process. 9.5         So that HMRC will become aware of indirect disposals, reporting obligations will be imposed on advisors who meet the following conditions: 9.5.1      The advisor is based in the UK; 9.5.2     The advisor is paid a fee for advice or services relating to a transaction within the new rules; 9.5.3      The advisor has reason to believe that a contract has been concluded for a disposal falling within the new regime; 9.5.4     The advisor cannot reasonably satisfy themselves that the transaction has been reported to HMRC. 9.6         The time limit for the advisor is 60 days – which should allow time for the non-resident to report the transaction himself, and show an official receipt for its report to its advisor. 9.7         HMRC will have powers to recover unpaid tax from a UK representative of a non-resident investor and from related companies. 9.8 Penalties and interest charges will be imposed for compliance failures. Conclusions 10.1        In some respects, the move by the UK Government to impose tax on foreign investors in UK real estate should come as no surprise. In a time of austerity, raising tax receipts is an important part of the public finances, and seeking tax from overseas investors (who have no vote) is an obvious target. 10.2       Imposing capital gains tax on international investors in real estate brings the UK in line with most other jurisdictions. 10.3       At the moment, all we have is a consultation document. The Government has stated that it will publish its response to the consultation in Summer 2018, together with draft legislation. The actual legislation will be introduced with the Finance Bill in April 2019, to take effect from April 2019. Until we have sight of the draft legislation, it is difficult to provide anything other than a high level overview of the proposals. 10.4       However, there are some immediate thoughts that come to mind. 10.5       First, consideration should be given to the timing of capital expenditure. If an amount to be spent on capex will not be immediately reflected in the value of the building, consideration should be given to deferring the expenditure until after April 2019. This is so the full amount of the expenditure is treated as “enhancement” expenditure for base cost purposes, rather than getting lost in the rebasing valuation as at April 2019. 10.6       Second, if property is currently owned through a company incorporated and resident in a country with a favourable tax treaty with the UK, disposals of interests in such company may be exempted from the new indirect disposal charge under the terms of the treaty (which under UK general tax rules will trump domestic law), at least until such time as the UK and the other jurisdiction amend the treaty (and, unless the new multilateral instrument process can be utilised, the process of amending tax treaties is rarely rapid). To the extent that such structures can be kept in place without changes, they should. 10.7       However, the anti-forestalling provisions will counteract any attempt to redomicile a structure that does not already benefit from treaty reliefs into a favourable treaty jurisdiction. Quite how the anti-forestalling provisions will apply is not stated in HMRC’s technical note, and may be challenging to implement without the consent of the other jurisdiction involved. 10.8       Third, international investors, who benefit from UK tax exemptions (otherwise than because of their non-resident status), may want to restructure their ownership arrangements in order to benefit from their tax-exempt status, particularly if they own UK property through special purpose vehicles resident outside the UK.. This could be of particular relevance to overseas pension funds and sovereign investors, who would not be liable to UK tax if they hold property directly (or through fiscally transparent entities). Any restructuring may need to be put into place before April 2019 to ensure that the restructuring does not itself trigger a tax charge under the new regime. 10.9       Fourth, the structure of the proposed arrangements can give rise to the possibility of tax being charged at multiple levels where property is held by an international property investment funds through SPVs. Depending upon the proportion of UK and non-UK properties held by the fund, charges could arise on the disposal of individual SPVs (owning UK properties) and on the disposal by investors in their holding in the fund. Staging and timing of disposals may be important to mitigate the impact of potential double tax charges, so that at the point at which investors realise their holding in the fund, it is no longer “property rich”. 10.10     Fifth, The use of tax efficient onshore-UK structures (such as UK REITs, PAIFs and ACSs), is likely to become more prevalent, if only to restrict any tax charge to just one layer, and not at multiple levels. However, the Consultation Document does state that the Government will be considering whether changes to these regimes will be required to prevent tax avoidance. 10.11      Sixth, the interaction between these new provisions and the Substantial Shareholder Exemption is not entirely clear from the Consultation Document. Whilst the application of SSE to Qualifying Institutional Investors is clearly preserved, it is unclear whether SSE would be available for disposals that would otherwise qualify for the SSE. This is of particular importance to active trading businesses (such as hotels and care homes) that have a significant property component to their overall valuation. In the case of OpCo-PropCo structures, depending upon how the provisions are legislated, there might be benefits in migrating PropCos into the UK so that they clearly qualify for SSE on a disposal of the entire business. 10.12     Finally, challenges will also bring opportunities. Although some investors may find that their after-tax return from UK property investment will be diminished as a result of these changes, investors who are already within the scope of UK tax (or exempt from tax) will be no worse off as a result of these changes, and may find opportunities for investment. It would be no surprise if the spectre of this legislation brings into play “price chip” discussions as cash-rich investors seek to capitalise on uncertainties that inevitably will feature in the minds of sellers. ________________________ [1]  See HM Treasury and HM Revenue & Custom Autumn Budget 2017 – Open Consultation on Taxing gains made by non-residents on UK immovable property (22 November 2017), available athttps://www.gov.uk/government/consultations/taxing-gains-made-by-non-residents-on-uk-immovable-property   The following Gibson Dunn lawyers assisted in preparing this client update: Nicholas Aleksander, Jeff Trinklein, Alan Samson, and Barbara Onuonga. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments. For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group and Real Estate Practice Group: Nicholas Aleksander – London (+44 (0)20 7071 4232, naleksander@gibsondunn.com) Jeffrey M. Trinklein – London/New York (+44 (0)20 7071 4224 +1 212-351-2344), jtrinklein@gibsondunn.com) Alan Samson – London (+44 (0)20 7071 4222, asamson@gibsondunn.com)   © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 5, 2017 |
Proposed Revised Capital Treatment for “High Volatility Commercial Real Estate”: More Loans Likely to Be Covered

On September 27, 2017, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (Agencies) issued a proposal (Proposal) that would amend some of the current Basel III capital rules – foremost among them, the heightened capital charge for so-called “high volatility commercial real estate” (HVCRE). The HVCRE capital charge has been controversial since the Agencies finalized the Basel III rules in 2013 (Final Basel Rule).  For real estate loans that qualify as HVCRE, the current capital charge is 50 percent higher than for unsecured commercial loans and real estate loans that do not qualify as HVCRE.  Moreover, the HVCRE capital charge is a form of U.S. “gold plating” of international capital standards – the HVCRE concept does not exist under the approach of the Basel Committee itself.  And there have been a host of interpretive questions on what exactly constitutes HVCRE – with some of the public Agency answers containing unexpectedly conservative glosses on the Final Basel Rule. The Proposal states that it is seeking to simplify HVCRE treatment.   To that end, it introduces a new concept – “high volatility acquisition, development, and construction” loans (HVADC) – and imposes a lower, but still “gold plated,” capital charge that is 30 percent higher than the capital charge for unsecured commercial loans and non-HVADC real estate loans. The Proposal is subject to a 60-day comment period beginning on publication in the Federal Register. Final Basel Rule HVCRE Capital Charge HVCRE treatment is most relevant under the Final Basel Rule’s so-called “standardized approach” to capital calculations.  All U.S. banking organizations use the standardized approach to some degree:  for most, it is the only relevant approach to calculating capital.  But it is also relevant to the largest, most sophisticated institutions that use “advanced approaches” to capital treatment, which permit the use of internal models.  This is because Dodd-Frank’s Collins Amendment requires such institutions to calculate capital under the standardized approach as well, and then use the approach that requires the most capital when reporting their capital ratios. Under the Final Basel Rule, an HVCRE loan is “a credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property,”[1] subject to certain exemptions.  These exemptions, in addition to permanent financings, which are not HVCRE, include: loans financing one- to four-family residential properties, certain “community development” real estate loans, loans financing the acquisition and development of agricultural land, and ADC loans that meet certain criteria, including compliance with minimum LTV ratios and a certain amount of borrower contributed capital. Loans that qualify for one of the exemptions are not subject to the heightened HVCRE capital charge. HVCRE treatment has spawned interpretive questions, perhaps the most important of which relates to the borrower contributed capital requirement of the fourth exemption above: (ii) The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ”as completed” value; and (iii) The borrower contributed the amount of capital required by paragraph (ii) of this definition before the [bank] advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.[2] Although the Final Rule seems very clear that only the 15 percent of “as completed” value contributed by the borrower as capital, “or” internally generated project earnings, is required to remain in the project until permanent financing is in place, the Agencies issued an FAQ answer that took a different position: “15. The definition of HVCRE includes a provision that “the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.” What does “contractually required” mean in this context? In order to meet this criterion in paragraph (4)(iii) of the HVCRE definition, the loan documentation must include terms requiring that all contributed or internally generated capital remain in the project throughout the life of the project. The borrower must not have the ability to withdraw either the capital contribution or the capital generated internally by the project prior to obtaining permanent financing, selling the project, or paying the loan in full.”[3] Approach of the Proposal The Proposal would replace the HVCRE definition in the standardized approach with the HVADC definition, which would apply to all credit facilities that “primarily” finance or refinance: the acquisition of vacant or developed land; the development of land to prepare to erect new structures, including, but not limited to, the laying of sewers or water pipes and demolishing existing structures; or the construction of buildings or dwellings, or other improvements including additions or alterations to existing structures.[4] “Primarily” would mean credit facilities “where more than 50 percent of loan proceeds will be used for” such activities.[5]  HVADC loans would carry a capital charge 30 percent higher than unsecured corporate loans and non-HVADC real estate loans. With respect to the use of proceeds test, the Agencies stated that they expect “every [ADC] transaction to be supported by . . . documentation of sources and uses of funds tailored to the specific project” and expect “each banking organization to have a process in place to review the intended use of funds” for an ADC project, “consistent with prudent underwriting practices.”[6] The Proposal would retain the exemptions for loans for one- to four-family residential properties, agricultural land acquisition loans, community development loans, and permanent financings.  It would not, however, include any exemption similar to the current Rule’s minimum LTV/ borrower contributed capital exemption. Exemptions from HVADC Treatment With respect to the one- to four-family residential property exemption, the Agencies stated that it would include “both loans to construct one- to four-family residential structures and loans that combine the land acquisition [and] development or construction of one- to four-family residential structures, either with or without a sales contract, including lot development loans.”[7]  It is not a condition to the exemption that a specific buyer for a property be identified. In addition, loans for the acquisition, development or construction of condominiums and cooperatives would not qualify for the exemption, unless the project contained fewer than five individual dwelling units.  If each unit in a project is separated by a dividing wall that extends from ground to roof  (rowhouses or townhouses), the unit would be considered a single residential property and qualify for the exemption.  So would a loan to finance tract development – i.e., a project with multiple properties, each of which contained a one- to four-family dwelling unit.  Loans used solely to acquire undeveloped land would not qualify. Simplifying changes are proposed for the exemptions for community development loans and loans for the development of agricultural land, but the Agencies stated they were not intended to be substantive modifications of the current Rule.  Agricultural land is intended to be broadly understood to encompass, for example, timberland and fish farms, but not related manufacturing or processing facilities, such as dairy processing plants. Permanent Loans The Proposal would provide more gloss on what constitutes a “permanent loan” than the current Rule.  A “permanent loan” would be a “prudently underwritten” loan that has a “clearly identified ongoing source of repayment sufficient to service amortizing principal and interest payments aside from the sale of the property.”[8]   However, current loan payments would not be required to be amortizing for a loan to be considered “permanent.”  Bridge loans would generally not be considered permanent loans, and a permanent loan would “not include a loan that finances or refinances a stabilization period or unsold lots or units of for-sale projects.”[9]  The Agencies did state that for certain owner-occupied projects, the owner “may have sufficient capacity at origination to repay the loan from ongoing operations, without relying on proceeds from the sale or lease of the property” – in which case the loan would be a permanent loan, and not an HVADC loan, at origination.[10] Grandfather Treatment The current HVCRE approach would continue until the Proposal was finalized, with the HVCRE status (or not) of loans existing at the time of a final rule being grandfathered.  The Proposal would therefore have prospective application only. Conclusion The Proposal demonstrates that the Agencies continue to believe that ADC loans pose greater risk than permanent financing of development properties (and unsecured commercial loans).  The Proposal, like the earlier Final Basel Rule itself, does not provide any empirical support for this belief, although it does state that “[i]n the preamble to the [Final Basel Rule], the agencies noted that their supervisory experience had demonstrated that [HVCRE] exposures . . . presented heightened risks.”[11] If finalized, the Proposal seems likely to subject a larger number of loans to “gold plated” capital treatment.  This result seems to reflect a determination by the Agencies that sorting out the full range of questions on the current Rule’s minimum LTV/borrower contributed capital exemption is too difficult an administrative task, although it is not clear why this should be the case. In simplifying the HVCRE approach, moreover, the Proposal is highly likely to be over-inclusive as a risk matter, because the HVADC test turns on the use of a loan’s proceeds, and not on its characteristics.  A loan that qualified for the minimum LTV/borrower contributed capital exemption under the current Rule, if made after the Proposal is finalized, could well be an HVADC exposure and thus require 30 percent more capital being held against it. It is therefore appropriate to question the calibration of the 30 percent heightened capital charge and the degree to which “gold plating” of international standards is even necessary.  It is also appropriate to question whether the Agencies should be providing more empirical support than asserted “supervisory experience” to justify more widespread gold plating.    [1]   See, e.g., 12 C.F.R. § 3.2.    [2]   See, e.g., id.    [3]   Agencies, Frequently Asked Questions on the Regulatory Capital Rule (April 6, 2015).    [4]   Proposed Rule, Regulatory Capital Rule: Simplification to the Capital Rule Pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of 1996. The HVADC revision does not apply to “advanced approaches” capital treatment.    [5]   Id.    [6]   Id.    [7]   Id.    [8]   Id.    [9]   Id. [10]   Id. [11]   Id. Gibson Dunn’s lawyers  are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions or Real Estate practice groups, or the following: Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Real Estate Group: Jesse Sharf – Los Angeles (+1 310-552-8512, jsharf@gibsondunn.com) Alan Samson – London (+44 (0) 20 7071 4222, asamson@gibsondunn.com) Eric M. Feuerstein – New York (+1 212-351-2323, efeuerstein@gibsondunn.com) Erin Rothfuss – San Francisco (+1 415-393-8218, erothfuss@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 6, 2017 |
Webcast: Enforcing Security Interests Outside of Bankruptcy: Remedies Under the Uniform Commercial Code

​Please join us for an informative hour-long webinar focusing on the enforcement of security interests outside of a bankruptcy proceeding. The presentation discusses the remedies provided to a secured creditor by the Uniform Commercial Code, including public and private foreclosure sales, retention of collateral and collection rights. In addition to a general discussion of the available remedies and procedures, the presentation will focus on issues arising in foreclosure upon mezzanine collateral, which is of particular relevance to real estate financing structures. View Slides [PDF] PANELISTS: Matthew K. Kelsey is a partner in the New York office of Gibson, Dunn & Crutcher and a member of Gibson Dunn’s Business Restructuring and Reorganization Practice Group. Mr. Kelsey’s practice focuses on representing companies, financial institutions and creditor groups inside and outside of Chapter 11 in numerous industries, including the financial, energy, manufacturing, construction and retail sectors. Sam Newman is a partner in the Los Angeles office of Gibson, Dunn & Crutcher and a member of both the Business Restructuring and Reorganization Group and the Corporate Department. His practice involves representing creditors, debtors and other parties-in-interest in Chapter 11 cases. He also advises buyers, sellers, lenders and borrowers in transactions involving distressed assets. Jesse Shapiro is a partner in the Los Angeles office of Gibson, Dunn & Crutcher. He is a member of the firm’s Real Estate Department. Mr. Shapiro’s practice experience includes representation of real estate funds, lenders, and institutional and non-institutional investors in all areas of real estate, including: acquisitions and dispositions; construction, mortgage (fee and leasehold), mezzanine and participating financing; loan restructuring and workouts; and forming and representing limited liability companies, general and limited partnerships and joint ventures. Daniel Denny is an associate in the Los Angeles office of Gibson, Dunn & Crutcher and is a member of both the Business Restructuring & Reorganization Group and the Corporate Department. Mr. Denny has a wide range of experience representing debtors, creditor groups and potential acquirers in distressed settings. Mr. Denny also has significant commercial real estate finance experience. Emily B. Speak is an associate in the Los Angeles office of Gibson, Dunn & Crutcher. She currently practices with the firm’s Corporate Department and is a member of its Global Finance and Business Restructuring and Reorganization Practice Groups. MCLE CREDIT INFORMATION: This program has been approved for credit in accordance with the requirements of the New York State Continuing Legal Education Board for a maximum of 1.0 credit hour, of which 1.0 credit hour may be applied toward the areas of professional practice requirement.  This course is approved for transitional/non-transitional credit. Attorneys seeking New York credit must obtain an Affirmation Form prior to watching the archived version of this webcast.  Please contact Jeanine McKeown (National Training Administrator), at 213-229-7140 or jmckeown@gibsondunn.com  to request the MCLE form. Gibson, Dunn & Crutcher LLP certifies that this activity has been approved for MCLE credit by the State Bar of California in the amount of 1.0 hour. California attorneys may claim “self-study” credit for viewing the archived version of this webcast.  No certificate of attendance is required for California “self-study” credit.

July 10, 2017 |
California Supreme Court Upholds Los Angeles County’s Interpretation of Documentary Transfer Tax Act

On June 29, 2017, in a widely anticipated ruling, the Supreme Court of California held that a transfer of an interest in a legal entity that results in a change in ownership of real property held by the legal entity for property tax purposes triggers the California documentary transfer tax (the "DTT").[1]  This decision affirms the lower court’s view that property tax "change in ownership" principles apply for purposes of the DTT. Facts of the Case As discussed in more detail in our prior Client Alert, Ardmore involved a series of transactions involving, over time, the transfer of an apartment building by a trust (Trust) to a wholly owned limited liability company (Ardmore), a transfer by the Trust of its interest in Ardmore to a "trust-owned partnership" (Partnership), a "distribution" of interests in the Partnership by the Trust to certain subtrusts of the Trust, and a "distribution" and "sale" of a 45% interest in the Partnership by the subtrusts to each of two other trusts formed for the grantor’s two sons (90% total transferred). The Los Angeles County Assessor concluded that the transaction resulted in a change in ownership of the apartment building and reappraised the property on that basis.  Ardmore did not dispute that the transactions resulted in a change in ownership of the property for property tax purposes and paid the supplemental property tax assessment.  Following the property tax assessment, the Los Angeles County Registrar-Recorder/County Clerk demanded that Ardmore pay DTT, asserting that the change in ownership for property tax purposes also gave rise to liability under the Documentary Transfer Tax Act (the DTTA).[2] California Property Tax/Change in Ownership California imposes real property tax based on the assessed value of real property.  Real property is reassessed to its appraised value whenever there is a "change in ownership."[3]  As a general matter, property owned by a legal entity is not reassessed upon a transfer of interests in the entity.[4]  The two most common exceptions to this rule relate to changes in control and original coowners.      A change in control occurs when a person obtains (directly or indirectly) more than 50% of the interests[5] in the entity.[6]  The "original coowner" exception applies only after property is transferred to an entity in an otherwise exempt transfer described in R&T Code section 62(a)(2).[7]  Under this exception, the owners of the transferee entity immediately after the exempt transfer become "original coowners," and if cumulatively more than 50% of the interests in the transferee entity are subsequently transferred by the original coowners, the property is considered to have undergone a change in ownership regardless of the fact that no one person obtained more than 50% of the interests in the transferee entity.[8] These rules were implemented following the passage of Proposition 13 in 1978.  The DTTA, including the exemptions discussed below, was enacted in 1967. The Court’s Opinion The Supreme Court of California, in a majority opinion joined by all but Justice Leondra Kruger, affirmed the lower court in holding that the sale of 90% of the interests in the Partnership subjected Ardmore to DTT. The Majority Opinion Authored by Justice Carol Corrigan, the majority held that a written instrument conveying an interest in a legal entity that owns real property may be taxable under the DTTA "as long as there is a written instrument reflecting a sale of the property for consideration"[9] – "even if the instrument does not directly reference the real property and is not recorded."[10]  The Court began with the text of R&T Code section 11911,[11] concluding that it, when read in context with other provisions of the DTTA, contemplates the application of the DTT to transfers of interests in a legal entity.  This conclusion was based largely on the Court’s interpretation of R&T Code section 11925, which provides that, in the case of realty held by a partnership or other entity classified as a partnership for federal income tax purposes (a tax partnership), no DTT is imposed as a result of a transfer of an interest in the tax partnership as long as certain requirements are met (namely that the tax partnership continues to hold the property and no termination of the tax partnership occurs under Section 708 of the Internal Revenue Code (Section 708)).  Without discussing the unique nature of partnerships and the "entity" versus "aggregate" treatment that has been applied to partnerships under both tax and non-tax law, the Court determined that the exception for continuing partnerships signified an intention by the legislature to apply the DTT to transfers of interests in entities.  Next, relying on federal authorities interpreting the former federal documentary stamp act (upon which the DTTA was based), the Court concluded that "federal courts often focused on whether there was a change in beneficial ownership of the real property" in determining whether the federal stamp act applied.[12]  In doing so, the Court distinguished United States v. Seattle Bank, in which the U.S. Supreme Court held that the transfer of real property resulting from a statutory consolidation of a national bank and state bank was not taxable under the federal stamp act.[13]  According to the Court, the U.S. Supreme Court in Seattle Bank did not decline to tax the transfer under the federal stamp act because there were no formal instruments directly referencing the real property transferred; rather, the transfer was not taxed "because the substance of the transfer did not involve the purchase or sale of property."[14] Combining the above principles, the Court concluded that the "critical factor" in determining whether the DTT may be imposed is whether there was a sale resulting in a transfer of beneficial ownership of real property and that the rules describing what constitutes a change in ownership for property tax purposes also apply for purposes of the DTTA,[15] notwithstanding that the property tax rules were issued a decade following enactment of the DTT statute.  Because certain transfers of interests in entities can constitute a change in ownership for property tax purposes,[16] the Court concluded that the DTT may be imposed "so long as there is a written instrument reflecting the sale of the property for consideration."[17] Justice Kruger’s Dissent In a dissenting opinion, Justice Leondra Kruger argued that the federal cases relied upon by the majority point to the conclusion that the DTTA should not apply to transfers in interests in legal entities that own real estate, that the DTTA and the property tax change in ownership rules were enacted at different times for different purposes, and that applying the change in ownership rules to the DTT raises difficult questions, including questions concerning valuation. Practical Implications While some California jurisdictions, including San Francisco, have already amended the DTT provisions of their municipal codes to include as "realty sold" any acquisition or transfer of ownership interests in a legal entity that results in a change of ownership of the underlying property for property tax purposes, Los Angeles never amended its municipal code to link the DTT with the property tax change in ownership rules.  Nevertheless, it is clear that Los Angeles will continue to apply the DTT to situations in which a property tax change in ownership occurs (assuming the exception in R&T Code section 11925(a), discussed below, does not apply).  In addition, other jurisdictions that have not amended the DTT provisions of their municipal codes may now rely on Ardmore to similarly impose the DTT in such situations. Worth noting is the exception in R&T Code section 11925(a), which remains intact.  Under this exception, no DTT is applied with respect to property held by a tax partnership upon the transfer of interests in such tax partnership if it is considered a continuing partnership within the meaning of Section 708 and it continues to hold the property.[18]  Thus, transfers of interests in a tax partnership should not result in a DTT if (a) the property is and continues to be held directly by the tax partnership, and (b) the transfer does not result in a termination of the tax partnership under Section 708.  This should be the case even if the transfer results in a change in ownership for property tax purposes.[19] Somewhat less clear is the result where the property is not held by the tax partnership directly, but rather is held by a subsidiary of the tax partnership, even if the subsidiary is disregarded for income tax purposes.  While those were the facts in Ardmore, the Court did not address this issue.[20]  If R&T Code section 11925 does not apply to property held in a subsidiary, then (a) the exception in R&T Code section 11925(a) to continuing partnerships likewise should not apply, and (b) the "exception to the exception" for Section 708 terminations in R&T Code section 11925(b) also should not apply.  For instance, if R&T Code section 11925 does not apply to property held in a subsidiary of a tax partnership, then (a) a transfer of interests in the tax partnership that does not trigger a Section 708 termination but that does result in a change in ownership for property tax purposes would trigger DTT on property held by the subsidiary, but (b) a transfer of interests in the tax partnership that does trigger a Section 708 termination but that does not result in a change in ownership for property tax purposes would not trigger DTT on property held by the subsidiary.[21] Interestingly, some cities and counties never amended their DTT provisions to reflect the application of Section 708 to entities that are not partnerships for state law purposes but are classified as partnerships for federal income tax purposes.  In theory, those cities and counties could claim that the exception for continuing partnerships does not apply to property that is held directly by another form of tax partnership, such as a limited liability company that is classified as a partnership for federal income tax purposes. As noted in Justice Kruger’s dissenting opinion, questions remain in determining how Ardmore will apply to future transactions, including the manner in which the tax is computed.  The majority opinion did not address the computational issues that arise when a less-than-100% transfer occurs.  The statute addresses this issue in situations where the property is owned by an partnership that terminates under Section 708.[22]  However, there is no comparable provision applicable to other entity interest transfers that now trigger a DTT.  The dissenting opinion uses as an example the possible transfer of the 10% remaining interest in the Partnership to one of the trusts that previously acquired 45%.  This transfer would result in another property tax change in ownership under R&T Code section 64(c)(1), and Justice Kruger questions whether that change in ownership would trigger yet another DTT on 100% of the value of the property.  Please contact any Gibson Dunn tax lawyer for updates on this issue.    [1]   926 Ardmore Ave., LLC, v. County of Los Angeles, S222329 (Cal. June 29, 2017).    [2]   Cal. Rev. & Tax. Code (R&T Code) § 11901 et seq.    [3]   California Constitution, Article XIIIA, Section 2(a).    [4]   R&T Code section 64(a).    [5]   Interests are determined by reference to voting stock in the case of a corporation, and profits and capital in the case of a partnership or limited liability company.  R&T Code section 64(c)(1); Rule 462.180 of Title 18, Division 1, Chapter 4, of the California Code of Regulations.    [6]   R&T Code section 64(c)(1).    [7]   These generally are transfers where the proportional interests of the transferors and transferees in the property remain the same after the transfer.    [8]   R&T Code section 64(d).    [9]   Slip opn. at 20. [10]   Slip opn. at 13. [11]   R&T Code section 11911 authorizes California counties to levy a tax on "each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers . . . ." [12]   Slip opn. at 17. [13]   United States v. Seattle Bank, 321 U.S. 583 (1944). [14]   Slip opn. at 17. [15]   Slip opn. at 19-20 (noting that "the change in ownership rules are designed to identify precisely the types of indirect real property transfers that the [DTTA] is designed to tax"). [16]   See discussion above under "California Property Tax/Change in Ownership." [17]   Slip opn. at 20. [18]   While Section 708 does not use the phrase "continuing partnership," this phrase fairly clearly should be read to refer to a tax partnership that does not terminate under Section 708. [19]   For example, assume tax partnership P that owns real property and is owned equally by three partners, A, B and C.  If A purchases the entire interest of B (and assuming no other relevant sales or exchanges occurred within 12 months), there would be a change in ownership for property tax purposes under R&T Code section 64(c)(1), but no termination of P under Section 708.  Therefore, absent other adverse facts, the transaction would not give rise to DTT. [20]   According to the Court, Ardmore conceded at trial that R&T Code section 11925 did not apply.  Slip opn. at 6, fn 7.  The opinion of the lower court (unpublished), however, stated that R&T Code section 11925 did not apply to the transaction, meaning whether a Section 708 termination occurred was immaterial to the lower court. [21]   For example, using the same facts as in footnote 19, if the property were held in a subsidiary of P and R&T Code section 11925 does not apply to property held in a subsidiary, then the purchase by B from A would give rise to DTT.  On the other hand, if A sold its entire interest in P to D and B concurrently sold its entire interest in P to E, while the transactions would result in a Section 708 termination, no property tax change in ownership would occur (again, assuming no other adverse facts) and therefore the DTT should not apply.      [22]   R&T Code section 11925(b) provides that "the partnership or other entity shall be treated as having executed an instrument whereby there was conveyed, for fair market value (exclusive of the value of any lien or encumbrance remaining thereon), all realty held by the partnership or other entity at the time of the termination."   Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these and other tax-related developments.  If you have any questions, please contact the Gibson Dunn lawyer with whom you usually work, any member of the Tax Practice Group, or any of the following: Los Angeles  Hatef Behnia (+1 213-229-7534, hbehnia@gibsondunn.com)Paul S. Issler (+1 213-229-7763, pissler@gibsondunn.com)Dora Arash (+1 213-229-7134, darash@gibsondunn.com) Orange County Scott Knutson (+1 949-451-3961, sknutson@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

June 20, 2017 |
Proposed New Disclosure Regime for Overseas Entities Owning UK Real Estate

A significant development is afoot which will impact foreign investors in UK real estate. Aside from the benefits of a stable and liquid real estate market in the UK and a favourable legal/tax regime, foreign investors have always been able to preserve their anonymity. That is about to change. The Government has signalled its intention to require overseas owners of UK real estate to publicly disclose their identity, in much the same manner as is the case with disclosures of owners of shares of UK companies (a change introduced in 2016). If implemented, the rules would require public disclosure of beneficial ownership of all entities engaged in buying, selling and financing UK real estate. Overseas entities that already own interests in UK real estate would be given 12 months to comply. At present, the proposal is in consultation and there is no fixed schedule for the enactment of enabling legislation. The Department of Business, Energy & Industrial Strategy ("BEIS") announced a call for evidence in April 2017 on the nature and a scope of a register which would be established to record who owns and controls overseas legal entities that own UK real estate. Responses to the call for evidence closed on 15 May 2017. BEIS expects that the proposed UK register for overseas entities will closely follow the regulations of the "persons with significant control" register (the "PSC Register") that already apply to UK companies, thus closing a loophole perceived by the Government in the overall beneficial ownership disclosure regime that operates in the UK. What is the proposal? In order to buy, sell, charge (i.e., grant a mortgage or security over), or grant a long lease of property in the UK, an overseas entity would be required to: (i) provide details to Companies House with information on the beneficial ownership of the overseas entity; and (ii) apply for a registration number. Registration of an effective transfer of any interest in UK real estate with the Land Registry will not be possible without a valid registration number. This means that an overseas entity that wishes to deal in property in the UK will not be permitted to do so without securing a valid registration number and ensuring that its interest in UK Property is properly noted in the register. Overseas entities that already own UK real estate will have a 12-month transitional period to apply for and obtain a registration number. Criminal sanctions are being considered as part of enhancing the enforcement of the regime (similar to the existing treatment that makes it a criminal offence to knowingly or recklessly provide false or misleading information to Companies House to comply with a filing obligation). Who is covered? All overseas entities, not just companies (i.e., body corporates, corporations, partnerships and trustees, etc.), that seek to buy, sell, charge (i.e., grant a mortgage or security over), or grant a long lease of property in the UK. What falls within the scope of UK real estate? Freehold property in the UK and leases of UK real estate with an initial term of more than 21 years (where the lease is required to be registered with the Land Registry – no further distinction is made between commercial and residential property in the proposal). Does this affect both registered and unregistered land? Notwithstanding that the UK has had a system of mandatory land registration since 1925, not all land in the UK is currently registered (BEIS estimates that 17% of freehold land in England and Wales is unregistered). Any unregistered land currently owned by an overseas entity will not be subject to the new register requirements. However, as a transfer of unregistered land triggers registration, the proposals will apply to overseas entities buying unregistered land (which will become registrable on completion). Who is the beneficial owner? The individual (or individuals) who ultimately benefits from the legal entity and who exercises control over it and the assets it holds. If ownership involves "chains" of intermediate entities, where another legal entity, rather than an individual, is the beneficial owner, the disclosure of all beneficial ownership up the ownership chain may be required until the ultimate individual beneficial owner(s) is/are disclosed. The UK government’s proposal is that the definition of beneficial ownership closely follow that used in the PSC Register for UK companies. Generally, the PSC Register requires disclosure of beneficial ownership by persons that (i) directly or indirectly hold more than 25% of the shares or voting rights, or (ii) have appointment or removal rights over a majority of directors, or (iii) exercise or have significant influence or control over the company or a trust or partnership, if that company/trust/partnership would be a disclosable beneficial owner. How will the new register work? Application for registration requires details of the beneficial ownership of the overseas entity to be disclosed to Companies House. If the application is successful, Companies House will allocate a registration number to the overseas entity. Companies House, like the PSC Register, will make the beneficial ownership information publicly available free of charge through its website. Registration of title to UK real estate will be prohibited without a valid registration number. Reported beneficial ownership information will need to be updated at least every two years. Changes of control above or below the reporting thresholds in the interim period would not trigger an immediate updating requirement. Overseas entities will need to include all information about all changes in beneficial ownership since the last update filed report. How will this affect UK real estate already owned by overseas entities? Overseas entities will have 12 months to apply for registration number. At expiry of the 12-month period, any overseas entity owning property in the UK will be prohibited from selling the property or granting a long (21+ years) lease or legal charge over it, if they have not complied with the new register’s requirements. What information of the beneficial owner will be included in the new register? The proposal is to follow as closely as practicable the PSC Register information requirements that currently apply to beneficial owners of shares in UK companies (i.e., name, date of birth, nationality, service address, residential address (will be disclosed to Companies House but not made publicly available), country or state where they usually reside, nature of its control of the overseas entity, date that control was acquired). The UK government would implement a protective regime allowing an individual to keep confidential certain information in limited circumstances, such as where disclosure of such information would put the individual at risk of violence or intimidation. Are there exceptions? In limited circumstances, an overseas entity may be permitted to state that it is unable to provide beneficial ownership information (e.g., it has not been able to confirm beneficial ownership information with the beneficial owner despite taking reasonable steps to do so or it has not been able to establish if there are any beneficial owners or there are no disclosable beneficial owners because all persons hold 25% or less of the shares, voting rights, etc. in the overseas entity). It will be an offence for anyone to knowingly or recklessly provide misleading or false information. Where overseas entities are unable to give beneficial ownership information, as a substitute they will be required to disclose information about their managing officers instead. The proposal acknowledges the need to avoid duplicative or double reporting (for instance if a beneficial owner of an overseas entity is required to publicly report equivalent beneficial ownership information in its home or other country). For example, where an overseas entity has a UK company as a beneficial owner, the overseas entity would disclose the UK company as a beneficial owner but need not disclose further "up" the chain, as that information will be included in the PSC Register of the UK company. What are the implications of the proposed register and next steps? The proposals are still in the process of consultation. The comment period closed 15 May 2017 and the comments are being assessed by BEIS. It remains to be seen whether the proposals will remain a priority of the new minority Government. Looking ahead: Overseas entities may want to review their constitutional documents (including shareholders’ agreement and similar agreements) and consider including provisions allowing the overseas entity to request and receive up-to-date beneficial ownership information from its beneficial owners on a periodic basis. Investment funds, etc. with a base of significant or a concentration of equity holders (meeting the threshold disclosure requirements) should consider targeting any such significant shareholders with supplemental agreements in which those equity holders agree to provide beneficial ownership information. The information requested by the proposed register would need to be excluded from any confidentiality obligations in any arrangements between the beneficial owner and the overseas entity and the overseas entity would need affirmative authority to disclosed confirmed beneficial ownership information in compliance with the proposed disclosure regime. A seller of UK real estate to an overseas entity will want to take steps to confirm that the overseas acquiring entity has a valid registration number sufficiently in advance of completion. A side effect of the proposal may be that parties consider more robust contractual remedies for failure to close, including larger deposits or additional circumstances in which the deposit is forfeited to the seller. A buyer or lessees (of a long lease) of UK real estate from an overseas entity will want to ensure that the title to the UK real estate will be registered by the Land Registry, and that any overseas entity holding the UK real estate has the details of its beneficial ownership registered before exchange of the property contract / long lease. The proposal acknowledges that the restriction on title to UK real estate (which seeks to prevent transfers in cases where the registration requirements have not been met) should not prevent lenders from enforcing their security. The proposals intend to allow an existing lender to enforce and sell UK real estate to any entity (with or without regard to registration) to recover its debt. However, there are still practical difficulties. The Loan Market Association, in its response on the BEIS call for evidence,[1] stated that legitimate lenders and receivers that should be entitled to rely on any provisions enabling the exercise of security and sale of UK real estate securing a loan free from a title restriction for lack of beneficial ownership reporting compliance. There are a number of alternatives that a secured party may chose in an enforcement scenario and any enabling provision will need to accommodate a wide variety outcomes (balanced against the Government’s stated need to ensure no loophole is created that allows an overseas entity to obtain the value of UK real estate without complying with beneficial ownership reporting regime). We expect a detailed debate surrounding the provisions with secured lenders and their advisors constituencies. Any uncertainty could be unnecessarily disruptive to the UK real estate finance community. New lending secured against UK real estate of an overseas entity not in compliance with the proposals (if enacted) would not be possible as the note on the register (of title to the UK real estate) will prevent this. This will, in turn, increase the need for lenders to confirm (as part of the usual "know your customer" processes) that the overseas borrower has registered or is in the process of registering under the beneficial ownership regime in time before the loan may be advanced. The additional checks could increase the time and cost to complete a transaction. It remains to be seen whether these measures could have an adverse impact on loan pricing and terms. In making these proposals, the UK government recognises the need to find an appropriate balance between the increasing desire for public transparency of ownership of real property and the benefits of a stable and liquid real estate market in the UK.    [1]  See "LMA responds to BEIS call for evidence on a register of beneficial owners of overseas companies that own UK property", 15 May 2017, available at http://www.lma.eu.com/legal-regulatory/submission-regulators (LMA member access only).   Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Real Estate practice group, or the authors in the firm’s London office: Alan Samson (+44 (0)20 7071 4222, asamson@gibsondunn.com) Wayne P.J. McArdle (+44 (0)20 7071 4237, wmcardle@gibsondunn.com) Cameron J. Barlow (+44 (0)20 7071 4278, cbarlow@gibsondunn.com) Claibourne S. Harrison (+44 (0)20 7071 4220, charrison@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 8, 2017 |
UK Private Fund Limited Partnerships

On 6 April 2017, the Legislative Reform (Private Fund Limited partnerships) Order 2017 ("LRO") came into force. The LRO amends the Limited Partnerships Act 1907 ("LPA") and introduces a new form of limited partnership, the ‘private fund limited partnership’ ("PFLP") for use as a fund vehicle. UK limited partnerships are often used as investment vehicles across a range of asset classes, including private equity and real estate, due to their organisational flexibility, tax transparency and limited liability for investors. UK limited partnerships have not been as popular in recent years as certain, more flexible, forms of limited partnerships are available in other jurisdictions. The intention of the LRO is to enhance the competitiveness of UK limited partnerships compared to limited partnerships in other jurisdictions by reducing the administrative burdens and complexities of limited partnerships and codifying activities that may be taken by limited partners without jeopardising their limited liability status. Establishing a PFLP Designation as a PFLP is voluntary and open to existing and new limited partnerships. A limited partnership can elect to become a PFLP by making a filing with Companies House subject to the following conditions: (i) the PFLP is constituted by an agreement in writing; and (ii) the PFLP is a ‘collective investment scheme’ as defined in section 235 of the Financial Services and Markets Act 2000 (ignoring the exemptions from such classification for these purposes). While we would expect that most limited partnerships would be able to meet these two conditions, certain limited partnerships may fall outside of the definition of ‘collective investment scheme’ if the limited partners have significant involvement in the day-to-day operations. As was the case under the LPA prior to amendment, a PFLP must include ‘limited partnership’ or ‘LP’ after its name, but its status as a PFLP need not be disclosed in its name. It will not therefore be immediately obvious whether a partnership is a PFLP unless the Companies House filings are inspected. Once designated as a PFLP, the limited partnership will not be able to reverse the election. Both an existing limited partnership and a new limited partnership can be designated as a PFLP. It may be necessary for an existing limited partnership to amend its limited partnership agreements in order to become designated as a PFLP. To be designated as a PFLP, the general partner of a limited partnership must file either form LP7 with Companies House at the time of the initial registration of the limited partnership or form LP8 if designation as a PFLP is sought after the initial registration of the limited partnership. Key changes White list:  Limited partnerships have traditionally been a popular investment structure as they offer flexibility, tax transparency and, provided limited partners do not take part in management, limited liability to the limited partners. One problematic area under the previous law was uncertainty as to the scope of activities a limited partner could be involved in without being considered to have taken part in management of the limited partnership, with the consequent loss of limited liability status. While the fundamental position remains the same (if a limited partner engages in management it loses its limited liability), the LRO introduces a ‘white list’ of permitted activities that limited partners can undertake without the risk of being found to have taken part in management (the inclusion of this white list brings the LPA into line with equivalent limited partnership regimes in other jurisdictions, such as Jersey, Guernsey and Luxembourg). The full ‘white list’ can be found here and includes: taking part in a decision about the variation of the limited partnership agreement, the nature of the limited partnership or a disposal or dissolution of the limited partnership; consulting or advising the general partner or manager about the limited partnership’s affairs or accounts; providing surety or acting as guarantor for the limited partnership; taking part in decisions authorising the general partner to incur, extend, vary or discharge debt of the limited partnership; approving the accounts of the limited partnership or valuations of its assets; taking part in decisions regarding changes to persons in charge of the day-to-day management of the limited partnership; taking part in a decision regarding the disposal of the limited partnership, or the acquisition of another business by the limited partnership; acting, or authorising a person to act, as a director, member, employee, officer or agent of, or a shareholder or partner in, a general partner of, or a manager or adviser to, the limited partnership (provided that this does not extend to taking part in management of the partnership’s business); and appointing or nominating a representative to a committee, for example to an advisory committee. The ‘white list’ is a non-exhaustive list of activities and, therefore, it remains the case that if a limited partner undertakes an activity which is not on the list, a determination of whether a limited partner has taken part in the management of the company (and thus liable for all debts and obligations of the limited partnership as if it were a general partner) will continue to be subject to case law. Capital contributions:  Limited partners are generally required to make capital contributions to a limited partnership upon admission and, if such capital contributions are returned during the term of the limited partnership they are then liable for the debts and obligations of the limited partnership up to the amount returned. In the fund context, this restriction was typically addressed by allocating limited partners’ commitments into loan and capital contribution elements, allowing for earlier repayment of loan commitments without any adverse consequences to the limited partners. Limited partners in PFLPs are not required to contribute capital on admission to the limited partnership and may withdraw any capital contributions made to a PFLP without incurring liability for the amount withdrawn. However, the ability to withdraw capital contributions without liability does not apply (i) to capital contributions made before 6 April 2017, or (ii) where a capital contribution was made before the limited partnership became a PFLP. Winding up:  The LRO removes the requirement for the limited partners of a PFLP to obtain a court order to wind up the limited partnership in circumstances where the general partner has been removed. In such circumstances, the limited partners can instead appoint a third party to wind up the limited partnership. The LRO provides limited partners with further comfort in the ‘white list’ of activities that the appointment of a third party to wind up the limited partnership will not constitute ‘taking part in the management’ of the limited partnership. Gazette notices:  The LRO removes certain administrative burdens on PFLPs, including the requirement for a Gazette notice to be published upon the assignment by a limited partner of its interest in a PLFP to give the assignment legal effect, for the purposes of the LPA. Fewer Companies House filings:  A PFLP will not be required to notify Companies House of changes to (i) the nature of the limited partnership’s business, (ii) the character of the limited partnership or (iii) the amount of capital contributions made to the limited partnership. *          *          * These changes should make UK limited partnerships more attractive as investment vehicles by streamlining administration and bringing the law surrounding unlimited liability of limited partners into line with equivalent limited partnership regimes in, for example, Jersey, Guernsey, the Cayman Islands and Luxembourg, which have in recent years introduced reforms to make structuring and operating private funds more efficient. We expect that a significant number of fund sponsors that use UK limited partnerships will choose to register new limited partnerships as PFLPs and fund sponsors that have looked elsewhere for the formation of limited partnerships may now consider UK limited partnerships as a viable alternative. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work or the authors: Wayne McArdle – Partner, London (+44 (0)20 7071 4237, WMcArdle@gibsondunn.com) Chézard F. Ameer – Partner, Dubai (+971 (0)4 318 4614, CAmeer@gibsondunn.com) Josh Tod – Of Counsel, London (+44 (0)20 7071 4157, JTod@gibsondunn.com) Edward A. Tran – Of Counsel, London (+44 (0)20 7071 4228, ETran@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

January 13, 2017 |
2016 Year-End German Law Update

Over the last eight years, the German economic recovery seemed very robust to any sort of political and financial turbulences occurring in the EU and world-wide. The economy was booming, unemployment rates were at their lowest since the Second World War, and state coffers were filled with record tax collections that allowed Germany to run debt-free current budget accounts for the third consecutive year. The last twelve months, however, have the potential to derail this great journey. While BREXIT would at first and foremost appear to be harmful to the British economy, there have already been some negative knock-on effects on German exports to the UK. The unraveling of the Transatlantic Trade and Investment Partnership (TTIP), coupled with new protectionist tones emanating from the U.S. and many other countries, constitute an even bigger challenge to the export oriented German industry. These risks are amplified by the threat of a gradual decomposition of the EU, in particular, if recent concerns caused by the Italian referendum to reject a constitutional reform materialize and lead to a new financial crisis of the EU’s second-largest debtor (by measure of national debt in relation to GDP). As if this were not enough to contend with, more uncertainty lies ahead with elections in France and the Netherlands that could lead to success for anti-European and protectionist parties, further destabilizing the EU. And, finally, the elections for Germany’s parliament in the fall of 2017 may well yield results that endanger what had been dubbed as Germany’s policy of the “safe pair of hands” (Politik der ruhigen Hand), Chancellor Merkel’s highly successful and admired approach to tackling the significant challenges facing Germany in a considered and pragmatic “no-nonsense”-way. In light of these fundamental challenges that are likely to occupy the daily news in the coming months, the changes in many laws and regulations presented in this German Law Update seem like a report from better days in the past that may soon be overtaken by events of a different magnitude that threaten to shake the fragile shell of the EU over the next few months. As every year, we thank our clients and friends for their continued support and interest in our services. We hope that you will gain valuable insights helping you to successfully focus and steer your projects and investments in Germany in 2017 and beyond. We promise to keep you updated on any developments impacting your way of doing business in and with Germany in these exciting times. Table of Contents         1.  Corporate, M&A 2.  Tax 3.  Finance, Insolvency and Restructuring 4.  Labor and Employment 5.  Real Estate 6.  Data Protection 7.  Compliance 8.  Antitrust and Merger Control 1.      Corporate, M&A 1.1       Corporate, M&A – Audit Reform – New Challenges for Supervisory Boards & Audit Committees The directly applicable European Regulation (EU) No 537/2014 on specific requirements regarding statutory audits of public-interest entities (Abschlussprüferverordnung – APVO) and the accompanying German Audit Reform Act (Abschlussprüferreformgesetz – AReG) took effect on June 17, 2016. The key change they introduced is the principle of rotation after 10 years for the statutory auditor of so-called public interest entities, meaning the statutory auditor of public interest entities must change after 10 years, although the 10-year period can be extended to 20 years as long as the entity puts in place a procurement process by which it solicits bids from other auditors. Correspondingly, the responsibilities of the supervisory board and its audit committee in connection with the auditing procedure have been further specified more precisely, in particular with a view to (i) the appointment procedure and (ii) the monitoring of the independence of the auditor regarding (a) audit fees and (b) prohibited non-audit services (section 5 APVO). Non-compliance with these requirements may be sanctioned as an administrative offence and, under certain circumstances, even as a criminal offence. In the course of the reform, the requirements for the composition of the supervisory board and its audit committee were amended to the effect that (i) the required financial expert no longer needs to be independent (which, however, in practice will rarely make a difference because the German Corporate Governance Codex (DCGK) continues to require the chairman of the audit committee to be independent and a financial expert) and (ii) sector competence is required for the supervisory board and the audit committee, that means that these bodies in their entirety are now required in the same sector in which the company operates. Members of supervisory boards and audit committees should therefore make sure that (i) they are aware of, and comply with, their new responsibilities in relation to the appointment and monitoring of the auditor, (ii) the rules of procedure of the respective bodies are amended in line with the new requirements and (iii) the rules for the composition of the respective bodies are complied with. Back to Top 1.2       Corporate, M&A – Direct Communication between Supervisory Board and Investors Over the last few years, supervisory boards of many German public companies have increasingly faced requests by investors for direct interaction. This is not, however, provided for under German statutory law for the typical two-tier board structure. The prevailing view used to be that any communication with investors was a matter of managing the company (rather than supervising it) and was therefore the responsibility of the management board and not of the supervisory board. A more flexible view deemed communication between investors and the chairman of the supervisory board permissible if such approach was aligned with the management board (“one voice policy”). On July 5, 2016, a prominent working group issued “Guiding Principles for Dialogue between Investor and Supervisory Board,” which aimed at providing practical guidance on such communications and, in particular, stipulated that the chairman of the supervisory board may enter into discussions with investors on topics in the sole responsibility of the supervisory board as long as this was generally aligned with the management. This initiative intensified the ongoing discussion, and was followed by a proposal of the governmental commission (Regierungskommission) in October 2016 to amend the German Corporate Governance Codex accordingly and to recommend that the chairman of the supervisory board should be prepared, within an appropriate framework, to discuss with investors topics relevant to the supervisory board. The discussion is still ongoing. While practitioners welcome the proposal as it is said to meet the respective needs in practice and already reflects common practice, some scholars warn that these proposals are not in line with currently applicable law. For the time being, supervisory board members are thus well advised to communicate with investors only if they are aligned with the management board. Back to Top 1.3       The Future of German Co-Determination: The Battle Goes On The application of German co-determination laws to foreign employees of German corporations remains one of the most volatile battlegrounds in the German courts as they contend with traditional German local doctrine, on the one hand, and potential implications of European Union law and the freedom of establishment (Niederlassungsfreiheit), as laid down by the Treaty on the Functioning of the European Union (TFEU), on the other hand (please see in this regard our 2015 Year-End Alert, section 1.5). Under German law, the Co-Determination Act (Mitbestimmungsgesetz), which necessitates equal employee representation on the supervisory board, applies to corporations with more than 2,000 employees. More than 500 employees trigger the application of the so-called German One-Third Participation Act (Drittelbeteiligungsgesetz), which requires one third of the supervisory board to be constituted of employee representatives. In the past the by far prevailing assumption was that only employees of the relevant German domiciled group companies have the right to vote and be elected to the supervisory board. Extending the application of co-determination laws to employees outside of Germany for purposes of the calculation of the threshold number of employees, and also granting foreign employees the right to vote and to be elected to the supervisory board would have considerable effects not only on German corporations but also on their foreign subsidiaries. Almost two years after a surprise decision by the District Court of Frankfurt am Main (Landgericht Frankfurt am Main) in February 2015 that held that non-German employees employed by foreign subsidiaries of a German corporation (Deutsche Börse AG) would also need to be counted towards the above thresholds and were entitled to vote for and be voted onto the supervisory board as employee representatives, the legal situation remains uncertain. The above decision is still on appeal and there are currently three other similar cases that are either pending before, or have been finally decided by, other regional courts in Bavaria (BayWa), Berlin (TUI) and Rhineland-Palatine (Hornbach) that have reached different conclusions (for a more detailed analysis, see the article by Lutz Englisch and Mark Zimmer in the Business Law Magazine). These contentious questions on the territorial and personal reach of the German co-determination laws will soon be decided by the European Court of Justice in the early part of 2017 in response to a request for a preliminary ruling from the Berlin High Court (Kammergericht Berlin). Such a preliminary ruling would settle the differences of opinion between the various German courts and provide guidelines on an EU-conform interpretation of the German co-determination laws. In the medium-term, subject to the reaction in Germany and abroad to the European Court of Justice’s decision in the case referred, this might also lead to a more aligned European-wide approach if the European Commission decides to include this in its company law agenda going forward. For companies potentially affected by these developments it remains key to monitor the outcome of the above litigation and carefully analyze their own factual situation and employee numbers in Germany and abroad in order to be in a position to react adequately to any future developments. Back to Top 1.4       Corporate, M&A – Shareholder Activism on the Rise? Activist shareholders in Germany have in the past generally exercised their influence offstage by (successfully) pressuring management into supporting the instalment of their representatives in the supervisory board. In the summer of 2016, however, Germany saw the first prominent proxy fight about supervisory board elections between the management of German public company STADA and the German activist shareholder AOC – Active Ownership Capital. AOC, holding approximately a 7% participation, was about to strike a deal with the supervisory board of STADA about AOC’s representation in the supervisory board which was later rejected by the company. After an extensive proxy fight during which, inter alia, STADA’s CEO resigned, AOC managed to have the chairman of the supervisory board (though no other board members) replaced during the shareholders meeting. Earlier this year, the German capital market experienced two severe short attacks: in March, a formerly unknown research entity (Zatarra) published a research report alleging fraud and corruption at Wirecard on a newly set-up webpage without disclosing the author(s). Concurrently, massive short positions had been built up. Wirecard’s share price dropped by approximately a third on this day. The author of the Zatarra report has not yet been identified nor have the report’s allegations been proven. Wirecard’s share price has recovered in the meantime. In April, New York-based hedge fund Muddy Waters published a report alleging a lack of transparency and indications of non-compliant behavior at German public company Stroer, in particular, in connection with related parties’ transactions. Muddy Waters, referring to a history of detecting non-compliant behavior at public companies, concurrently explained that it had acquired significant short positions since it expected the share price of Stroer to drop. Stroer’s share price dropped by approximately 30% on that day and has not recovered since. Back to Top 1.5       Corporate, M&A – New European Market Abuse Regime – Extended Scope and Increased Sanctions On July 3, 2016, the European Market Abuse Regulation (“MAR“) came into force, creating a new regulatory framework on market abuse across the European Union (EU). The parts of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) dealing with insider dealing, ad hoc disclosure, director’s dealings and market manipulation have been replaced by the provisions of the MAR. On the same day, changes to the WpHG with regard to criminal sanctions for the violation of market abuse rules came into force which implemented requirements of the European Directive on Criminal Sanctions for Market Abuse (“CRIM-MAD“). Together, the MAR and the CRIM-MAD have extended the scope of the market abuse regime and incorporated a wider range of more stringent sanctions. Some of the key changes implemented by the MAR include: Scope: The rules regarding ad hoc disclosure, manager’s transactions and maintenance of insider lists now also apply to issuers who have approved trading of their financial instruments on a multilateral trading facility (“MTF“) or organized trading facility (“OTF“) or have requested admission to trading of their financial instruments on an MTF. Examples of MTFs include the Euro MTF in Luxembourg and the Open Market (Freiverkehr) of the Frankfurt Stock Exchange. Insider dealing: The use of inside information to amend or cancel an order is now considered to be insider dealing. In addition, MAR sets out certain types of “legitimate behavior” which do not constitute insider dealing. MAR clarifies that stake-building in the context of a public takeover offer by an investor who obtained inside information concerning the target does not fall under the legitimate behavior exemption. Market sounding: MAR permits inside information to be legitimately disclosed to potential investors and shareholders for the purposes of a market sounding subject to certain prescribed and detailed steps which need to be taken by any issuer or person acting on an issuer’s behalf (e.g., brokers or investment banks) prior to conducting a market sounding. Detailed record keeping requirements are also imposed under MAR. Delaying disclosure of inside information: As before, an issuer may delay the disclosure of inside information, provided certain conditions are satisfied. However, outstanding approval from the supervisory board may only qualify as a legitimate interest for delaying disclosure if it is not certain that the supervisory board will approve the decision. Further, if rumors with sufficiently concrete information are spreading, irrespective of whether or not the rumors originated from the issuer’s sphere, it is assumed that the information’s confidentiality can no longer be ensured and, consequently, the issuer is not justified in delaying disclosure, but must disclose the inside information to the public as soon as possible. Manager’s transactions: The scope of the disclosure regime regarding transactions in the issuer’s shares or other financial instruments by “persons discharging managerial responsibilities” (“PDMRs“) and persons closely associated with them has broadened, and requirements as to form, timing and permitted exceptions have become stricter. Dealings in debt instruments and related financial instruments are now generally within the scope of MAR. In addition, MAR introduced so-called “closed periods” during which PDMRs are prohibited from dealings subject to certain exceptions. The duration of the prohibition is 30 calendar days prior to the “announcement” of a mandatory interim financial report or year-end report. Under certain circumstances, “announcement” can also be the publication of preliminary financial results. Market manipulation: MAR extends market manipulation to the manipulation of certain benchmarks and indices as well as to manipulative high-frequency trading. The market manipulation offence now also covers attempted manipulation. MAR leaves it up to the national competent authorities jointly with ESMA (European Securities and Markets Authority) to establish “accepted market practices” (“AMPs“) which will not be treated as market manipulation. The German Federal Financial Supervisory Authority has not yet established any AMPs. Sanctions: Monetary fines for the violation of the market abuse rules have been increased to up to EUR 5 million for an individual, and EUR 15 million or 15 per cent of the annual turnover for a firm. For example, fines of up to EUR 2.5 million or 2 per cent of the annual turnover can be imposed on a firm for the violation of ad hoc disclosure rules. In addition, sanctions available to the national competent authorities now also include public warnings (also known as “naming and shaming”) and temporary or permanent occupational bans of individuals. Back to Top 1.6       Corporate, M&A – Balance Sheet Guarantees – New Liability Risks for Sellers Balance sheet guarantees (representations and warranties) in share sale and purchase agreements can be considered standard. Often sellers feel comfortable to agree on such a guarantee, in particular, when the annual financial statements are audited. On the other hand, most sellers are reluctant to grant an additional undisclosed liability guarantee on “the absence of liabilities except as set forth in the most recent year-end balance sheet.” A ruling of the Higher District Court of Frankfurt am Main (Oberlandesgericht Frankfurt am Main) of May 2015 which was only published in 2016 appears to have rendered the distinction between a balance sheet guarantee and a guarantee on the absence of liabilities obsolete in certain cases. In the case before the court, the seller seems to have agreed on a clause comparable to the following clause: “The audited financial statements of XY-GmbH have been prepared with the care of a prudent business person (mit der Sorgfalt eines ordentlichen Kaufmanns) in accordance with German local generally accepted accounting principles (“GAAP”), including valuation principles (Bewertungsgrundsätze), consistent with past accounting and valuation practices, and present a true and fair view of the assets and liabilities (Vermögenslage), financial position (Finanzlage) and earnings position (Ertragslage) of XY-GmbH.” The Higher District Court of Frankfurt am Main held that clauses of the aforementioned type amount to a hard or objective balance sheet guarantee. As a consequence, the seller was held to be in breach even though the seller was not and could not have been aware of the liability in question when the annual financials were drawn up and even though the relevant accounts were, thus, in all respects in line with applicable accounting principles and were audited accordingly. Effectively, the ruling has the potential to turn balance sheet guarantees into a catch-all clause in cases where the requirements of other more specific guarantees are not met. The Frankfurt court went on to rule that the loss suffered by the purchaser consisted of the difference between the purchase price which was calculated on the basis of the available balance sheet and the purchase price which would have been arrived at had the additional liability been reflected therein. In contrast, the Higher District Court of Munich (Oberlandesgericht München) had some years earlier held that the loss is the amount of the relevant liability which was disregarded. Depending on the circumstances, the loss suffered by a purchaser can be higher or lower depending on which of the different calculation methods is applied. There are also cases where a purchaser would not have insisted on a lower purchase price, for example if the key decisive element for the purchaser were certain assets such as real estate or IP, which are unrelated to the disregarded liability. As a seller is often not aware of the components and drivers of the purchaser’s price calculation, balance sheet guarantees create an unforeseeable risk for sellers on the basis of the ruling of the Frankfurt Higher District Court. In order to avoid this, first of all, sellers need to be aware of the scope of the balance sheet guarantee. Secondly, precise wording will be key and even greater care will need to be taken when drafting balance sheet guarantees. In order to avoid that a balance sheet guarantee is later construed as objective, sellers could try to negotiate knowledge qualifiers. Moreover, sellers may consider linking the “true and fair view” part of the guarantee to the applicable accounting principles. For the assessment of the liability risks, a seller should further insist on a precise provision that sets out the loss calculation methodology specifically for balance sheet guarantees. Back to Top 1.7       Corporate, M&A – Sell-Side M&A Transactions and Pitfalls for Management Liability The decision of the Higher District Court of Munich (Oberlandesgericht München) dated July 8, 2015 adds another chapter to the expanding canon of potential management liability in M&A transactions. This time, however, not on the buyer’s side – where managing directors traditionally might find themselves confronted with allegations that they did not conduct a thorough due diligence – but on the seller’s side. In this case, the company claimed damages from its former managing director for an alleged violation of his managerial duties regarding the sale of a second-tier subsidiary in an auction process. Under German limited liability companies law, managing directors must – in fulfilment of their duties and obligations – exercise the due care and diligence of a prudent business person and may be held liable if their conduct is found to fall below this standard of care. Regarding business decisions (unternehmerische Entscheidungen), the so-called business judgement rule constitutes a safe harbor for the managing director. He cannot be held liable for failing to meet the above duty of care if, (i) at the time of taking the decision, (ii) he or she acted free of private interests and inappropriate influences, (iii) on the basis of adequate information, and (iv) for the benefit of the company. This business judgement rule does not apply in the case of a breach of a legal duty, i.e. if the law requires a certain decision or conduct. In the case at hand the company took the view that the insufficient information given to the shareholder of the company as regards the sale of the company’s second-tier subsidiary, in particular, caused a violation of the duties of the managing director. The question of whether or not the shareholder is sufficiently informed is a legal and not a business question. Thus, the business judgement rule does not apply. The Higher District Court of Munich, however, referred to an earlier ruling of the German Federal Supreme Court (Bundesgerichtshof, BGH) and held that the company had to prove that (i) damage was caused by the managing director and (ii) that it was caused by the managing director acting “potentially in breach of a duty”. In the present case, the court held that the managing director was not liable because the company had failed to prove that he had a duty to inform the shareholder in a certain way. The court stressed that such a high standard as regards the requirement to prove an alleged potential breach of duty by the managing director is necessary to rebut the statutory presumption that the managing director is liable once damage has been proven. Despite the managing director ultimately not being held liable, the present case shows that M&A transactions may involve significant risks for managing directors not only on the buyer’s but also on the seller’s side: if the transaction turns out to be less successful than anticipated by the company or its shareholder, sellers may try to look for a “scapegoat.” As it is easier to prove breaches of legal duties such as the provision of insufficient information or non-compliance with reporting lines, this may be their preferred route. For managing directors, it is, thus, of utmost importance to have clear competencies and reporting lines. They have to ensure that they are in a position where they know who is to be informed when and which internal reporting and consent requirements exist in a transaction, in particular if a final transaction agreement deviates from an already approved draft of such an agreement. Back to Top 2.      Tax – German Year-End Tax Update Corporate: Country-by-Country reporting and obligations to prepare master and local files: On December 16, 2016, the German legislator passed a tax law that transposes a specific recommendation of the final OECD Report on Base Erosion and Profit Shifting (OECD-BEPS Report) into German tax law. The recommendation, which has now become German law, is a standardized approach to transfer pricing documentation. The new transfer pricing documentation regime requires German multinational enterprises (MNE) to provide the German tax administration with a three-item documentation package consisting of a country-by-country (CbC) report, a “master file” and a “local file.” The CbC report has to be filed by the German head of a consolidated group with a consolidated turnover of more than EUR 750 million and, at least, one foreign consolidated subsidiary. It has to provide annually and for each tax jurisdiction, in which the group is engaged, an overview of the financial data including the aggregate allocation of income, taxes and business activities. The master file, which has to be filed by a German MNE that belongs to a group and has an annual turnover of at least EUR 100 million, has to include high-level information regarding its global business operations and transfer pricing policies. Detailed transactional transfer pricing documentations are provided in a local file that, for domestic entities, identifies materially related party transactions, the amounts involved in those transactions and the company’s analysis of the transfer pricing determination it has made with regard to those transactions. The obligation to prepare a local file is, in essence, already in existence under the current transfer pricing documentation regime and does not require a specific turnover threshold. While the CbC report would have to be filed with the tax administration no later than 12 months after the end of each fiscal year, the master and local files need to be prepared upon request by the tax authorities in the course of a tax audit and within a 60 day period (30 days for extraordinary business transactions) after the request. The new rules regarding master and local files apply as of January 1, 2017. The CbC reporting already applies to fiscal years beginning after December 2015. In addition to the new transfer pricing documentation regime, Germany also transposed into national law the automatic information exchange between EU Member States on tax rulings for cross border transactions and transfer pricing purposes. The new law is based on the EU Mutual Assistance Directive on Automatic Exchange of Information and Transfer Pricing Documentation as agreed between the EU Member States on December 8, 2015. The new rules on transfer pricing documentation and information exchange are the first important measures taken by Germany to implement the OECD-BEPS Report into German law. Further legislative measures on BEPS are expected until 2018, namely with respect to the taxation of controlled foreign companies and anti-hybrid rules for outbound payments made by German entities. Corporate: Loss limitation rules – exemption for business continuation losses: Also on December 16, 2016, a new exemption from the tax loss limitation rules for “business continuation losses” was incorporated in the Corporate Income Tax Act (Körperschaftsteuergesetz – KStG). The new law allows German companies that are undergoing a transfer in ownership, to take advantage of tax loss carryforwards they are currently precluded from using. Under the tax loss limitation rules, tax loss carryforwards of a corporation are forfeited on a pro rata basis if within a five years’ period more than 25 % but not more than 50% of the shares in the loss making entity are transferred. If more than 50% are transferred, the loss carryforwards will be forfeited in total. Exemptions from the loss limitation rules already exist for certain internal group reorganizations and to the extent that taxable built-in gains in assets exist at the level of the loss making entity. Under the new exemption, which targets to promote the venture capital industry, the tax loss limitation rule would not be applicable where the business operations of the loss making entity are continued and unchanged from the time of incorporation or at least during 3 years before the change in ownership, whichever is shorter. Upon application, regular tax loss carryforwards would be transformed into a “business continuation tax loss carryforward” and can still be used after a change in ownership. However, the business continuation tax loss carryforward would be forfeited, if, until the end of the year in which the share transfer took place, (i) the business operations are temporarily or finally discontinued, (ii) the purpose of the business operation is changed, (iii) additional new business operations are taken over, (iv) partnerships are acquired, (v) the corporation becomes a parent in a tax group or (vi) assets are contributed at less than the fair market value. Criteria to be taken into account in determining whether business operations have changed or new business operations have been added are, e.g., the type of services and goods offered by the company, the supplier and customer base, any key market areas and the qualification of the employees. The contribution of capital by the shareholder does not qualify as a change in business operations. The new rule is applicable to ownership transfers that occur after December 31, 2015 and applies for both corporate and trade tax purposes. Real Estate: Potential abolishment of the 95% hurdle for real estate transfer tax purposes: Real estate transfer tax (RETT – Grunderwerbsteuer) is imposed on asset deals that cause a change in the ownership of German real property. The tax rate is between 3.5% and 6.5% of the purchase price depending on the location of the real property in Germany. In share deals, RETT is also triggered by an acquisition of shares in a German or non-German corporation or partnership owning German real property if, after the transfer, at least 95% of the shares are held by the acquirer, new partners of the partnership or by a group of controlled companies (e.g. members of a tax group). While the RETT cannot be avoided in asset deals, the 95% hurdle in share deals has given rise to structuring considerations in order to prevent the application of RETT. The most commonly known structure is the “94/6 %” transfer, according to which 6% of the shares remain with the seller or – in case of corporations – are transferred to third parties unrelated with the acquirer. According to market estimates, around 65% of all German real estate deals with a volume above EUR 100 million are structured via share deals. The German Federal States (Bundesländer) are entitled to collect RETT. Several Federal States have now started an initiative to reform the RETT law and to broaden the scope of RETT for share deals. Current proposals are to lower the threshold, according to which the share deal is subject to RETT, from 95% to 75% or even abolish the threshold altogether and subject the share deal to RETT pro rata to the amount of shareholding acquired. For example, an acquisition of 35% of the shares in a real estate holding entity would then trigger RETT on 35% of the tax basis. Until now, a draft law with proposed changes has not yet been circulated. However, it appears likely that in the course of 2017 the legislative process to amend the RETT law will be initiated. Market participants are therefore advised to closely monitor further developments and consider the impact of potential changes on existing structures and future deals. Back to Top 3.      Finance, Insolvency and Restructuring 3.1       Finance, Insolvency and Restructuring – German Federal Supreme Court Clarifies Treatment of D&O Insurance in Insolvency Proceedings On April 14, 2016, the German Federal Supreme Court (Bundesgerichtshof, BGH) handed down an important decision regarding the treatment of D&O insurance policies in insolvency. German corporations are not obliged to enter into such D&O insurance policies in favor of their officers. If a corporation does enter into such an insurance policy and later becomes insolvent, insolvency administrators often terminate such contracts as a mutually not fully satisfied contract. In this case, the insolvency administrator later asserted personal liability claims against management of the debtor for alleged breaches of their managerial duties. The managers lodged a counterclaim against the insolvency administrator, arguing that the termination of the D&O insurance policy in insolvency was a breach of the insolvency administrator’s duties which resulted in rendering them personally liable to the insolvent estate for damages that otherwise would have been covered under the D&O insurance policy. The BGH dismissed the counterclaim by clearly stating that the insolvency-specific duties of the insolvency administrator are owed only to the debtor, the various groups of creditors or persons with a right to preferred satisfaction, but not to the corporate bodies of the debtor. The managers in question were not therefore owed any insolvency-specific duties by the plaintiff insolvency administrator. The court did, however, note in an obiter dictum that the interests of the creditors (not of management) may in certain cases require the insolvency administrator to consider maintaining the D&O insurance coverage after the opening of insolvency proceedings (Insolvenzeröffnung) if it is predictable at that stage that potential insurance coverage is beneficial for the insolvent estate because management is likely unable to pay any claims raised against them personally due to the scope of such damages. In such cases, the benefits of insurance recourse outweigh the savings made on no longer paying insurance rates to the insurer. Bearing in mind that the D&O insurance contract is entered into by the corporation with the insurer in favor of its officers, management and other beneficiaries of a D&O insurance policy might be well advised to contact the insolvency administrator early after the filing of the insolvency proceedings and before a decision on the continuation of the D&O insurance policy has been taken. At that stage, it often is possible to reach a negotiated solution on the continuation of D&O coverage, if necessary by offering to pay the insurance rates on behalf of the corporation during insolvency, thus removing the insolvency administrator’s incentive to terminate the insurance. Back to Top 3.2.      Finance, Insolvency and Restructuring Prompt (Re-)Action by German Legislator to Preserve Financial Stability – Netting Arrangements and the German Insolvency Code In December 2016, the German legislator passed an amendment to Section 104 of the German Insolvency Code (InsO) thereby retroactively annulling the effects of an earlier landmark ruling of the German Federal Supreme Court (Bundesgerichtshof, BGH) which only six months earlier had held netting arrangements in derivative transactions to be void in insolvency and had caused an outcry by the financial sector. On June 9, 2016, the Bundesgerichtshof held that certain provisions of an option agreement on SAP stock entered into on the basis of the German master agreement for financial derivative transactions (“German Master Agreement“) were void due to an infringement of the mandatory provisions of Sections 104, 119 of the German Insolvency Code (InsO) which aim at preventing speculative dealings by an insolvency administrator to the detriment of the insolvent estate. The German Federal Supreme Court held that the German Master Agreement infringed Section 104 InsO to the extent that (i) the option agreement terminated automatically upon an insolvency filing, (ii) the compensation claim of the insolvent debtor was contractually restricted in the German Master Agreement, and (iii) the provisions on the calculation method of the respective parties’ claims against each other also deviated from Section 104 InsO. The likely knock-on effects of the ruling beyond the case decided were considered momentous. Firstly, netting arrangements are rather standard not only in the German Master Agreement but in comparable standard contracts worldwide, e.g. in the ISDA (International Swaps and Derivatives Association) Master Agreement. Secondly, subject to certain exceptions, the ruling applied whenever German insolvency proceedings were opened (eröffnet) in respect of one of the contracting parties to such an agreement. Thirdly, potential regulatory effects were also deemed likely. There was a risk that, in view of the limitations imposed by Section 104 InsO, netting arrangements may no longer be recognizable under the Capital Requirements Regulation (“CRR”, EU No. 575/2013 of the European Parliament and Council), and could potentially lead to increased collateral requirements under the European Market Infrastructure Regulation (“EMIR”, EU No. 648/2012 of the European Parliament and Council). In view of the potential effects on the financial markets, the German Federal Government already announced on the day of the ruling that it would take the required action to ensure that standard master agreements would continue to be recognized in the market and by regulatory authorities. Also, on the very same day the German Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – BaFin) issued a decree (Allgemeinverfügung) to counteract the effects of the ruling for certain market participants in the interim period until December 31, 2016 (General Administrative Act by the Federal Financial Supervisory Authority of June 9, 2016) to ensure legal certainty for netting agreements also within the scope of German insolvency law. On December 16, 2016, the Federal Council (Bundesrat, the second chamber of the German legislative body) voted in favor of granting derivative transactions a preferential treatment for purposes of Section 104 InsO. The amended version of this provision will preserve the netting option with the result of a single claim of one of the parties, and market participants will be given the necessary flexibility in the calculation of close-out amounts and the date on which the respective derivative transactions are terminated in case of an insolvency of a contract partner thereto, as long as the basic principles of the underlying statutory provisions are respected. The preferential handling of derivative transactions will likely enter into force in January 2017 and will apply retroactively to all insolvency applications filed on or after July 10, 2016. Thus, the German legislator took the opportunity to respond promptly to the requirements of the (German) financial markets in a case where real risks for the financial stability of (mostly German) market participants loomed on the horizon. The amended version of Section 104 InsO also assists in safeguarding the international competitiveness of German market participants. Back to Top 4.      Labor and Employment 4.1       Labor and Employment – Tightened Rules for Hiring Temporary Workers As of April 1, 2017, a new law comes into effect which intends to put an end to what the government perceives as an abuse of temporary workers (“Temps“). The most important new rules are the following: Maximum Temp period limited to 18 months; Equal treatment of Temps with customer’s employees after nine months; Stricter formalities in contract between Temp agency and customer; Temps not to be used as strike-breakers; Temps count towards co-determination thresholds at customer’s after six months. While these new rules will indeed make the handling of Temps more burdensome, there will still be (legal) work-arounds, e.g. limiting the working period of a particular Temp to six or nine months. In any case, particular care should be given to the requirements set out in the agreement between the Temp agency and the customer that the person being supplied to the customer needs to meet. Back to Top 4.2       Labor and Employment – Transparency Rules to Avoid Gender Pay Gap In its quest for equal pay between the genders, the German Family Ministry has proposed legislation to enhance transparency regarding compensation. According to the ministry’s draft, companies (in Germany) with over 200 employees would be subject to provide certain information upon request by employees. Each individual employee could ask the company to disclose: the criteria and process for determining his/her own compensation; and the compensation paid to colleagues of the opposite sex performing the same or equivalent work. With regard to the second bullet point, the employer would have to determine the median of the compensation paid to all (!) opposite-sex colleagues doing the same or equivalent job as the claimant. Obviously, this could be quite a burdensome undertaking for employers. Yet, it is unclear, whether the intended goal of closing the gender pay gap would be reached by this complicated mechanism. In this context, it should be borne in mind that class actions are not established in Germany, so every employee feeling disadvantaged would have to individually claim said disclosure by the company. Whilst employers should be aware of the new legislation and monitor its legislative progress, such claims are not expected to be widespread: the ministry itself reckons that only 1% of eligible employees will make use of this right. Back to Top 4.3       Labor and Employment – Plans to Reform the Company Pensions Act The German government intends to limit companies’ liability with regard to occupational pension schemes by allowing defined contribution in addition to defined benefit schemes. So far only the latter are acknowledged as company pension schemes. Due to this fact and strict investment restrictions for pension plan managers, German companies are currently struggling to meet the defined benefit goals in light of the current extremely low interest rates. In order to relieve such pressure and to make company pension plans more attractive for employers, the government now wants to allow plans without a certain benefit guarantee, which would initially open the door to pure defined contribution schemes. However, according to the current plan, such defined contribution schemes will only be possible on the basis of a collective bargaining agreement with the union. It has yet to be determined whether and how these plans will become law. The reactions from several lobby groups were not particularly welcoming. Even if the law is enacted in the remaining six months of this parliamentary period, it would not take effect before January 2018. Back to Top 5.      Real Estate 5.1       Real Estate – Transfer of Lease by Operation of Law Pursuant to Section 566 of the German Civil Code (Bürgerliches Gesetzbuch – BGB), real estate lease agreements automatically transfer to an acquirer of the underlying real property by operation of law if the transferor is both the landlord and the owner of the property. The transfer of the lease takes effect, once the acquirer has been registered in the land register as the new owner of the property. In its decision of April 5, 2016, the German Federal Supreme Court (Bundesgerichtshof, BGH) confirmed that lease agreements only transfer to the acquirer of the property by operation of law if the lease is still effective and the tenant is (still) in possession of the leased premises at the time when the acquirer is registered as the new owner of the property in the land register which could take several weeks or even months. The tenant may hold the original landlord liable for damages if the lease agreement is not transferred to the acquirer of the property as new landlord and the tenant is, consequently, no longer entitled to use the leased premises. Therefore, the original landlord and the transferor should procure that the lease agreement is expressly and contractually (rather than by operation of law only) transferred to the acquirer and/or the acquirer, at least, assumes the obligations under the lease agreement. Back to Top 5.2       Real Estate — Disclosure Obligations and Liability of the Property Seller According to the statutory warranty regime in Section 433 et seq. of the German Civil Code (Bürgerliches Gesetzbuch – BGB), the seller of real property located in Germany shall transfer the property to the purchaser free from any defects in quality and/or in title. If the sold property is not free from such defects, the purchaser may request remediation of such defects, rescind the purchase agreement, reduce the purchase price and/or claim damages. German property sale agreements almost always restrict this statutory warranty regime or replace it with a regime agreed upon by the parties of the sale agreement. Pursuant to Section 444 BGB, the seller, however, is not entitled to invoke any agreed upon restriction and/or waiver of the statutory warranty regime, to the extent that the seller fraudulently concealed (arglistig verschwiegen) the defect and/or gave a corresponding guarantee; consequently, the broad statutory warranty regime applies in such a case. On July 8, 2016, the German Federal Supreme Court (Bundesgerichtshof – BGH) ruled that a sold property generally exhibits a defect if the prior use of this property poses the risk of significant pollution. The seller fraudulently conceals such a defect if the seller knows or suspects that the defect exists and, at the same time, knows or expects and accepts (damit rechnen und billigend in Kauf nehmen) that the purchaser is not aware of this defect. The seller of German property is therefore compelled to disclose to the purchaser any suspected previous use of the sold property that may pose a risk of significant pollution to avoid liability under the broad statutory warranty regime. Back to Top 6.      Data Protection 6.1       Data Protection – EU Data Protection Regulation In May 2018, the European General Data Protection Regulation (“GDPR“) will come into force. Although European regulations have direct effect in Member States, the GDPR provides for an unusually high number of opening clauses granting Member States the liberty to address certain data protection issues which the GDPR does not explicitly regulate. As the German legislator is planning to make use of several of these opening clauses and to ensure that the German Federal Data Protection Act (“FDPA“) complies with the GDPR and the new Data Protection Directive ((EU) 2016/680), it is currently preparing a comprehensive reform of the FDPA. After the Government’s first draft of September 5, 2016 was withdrawn due to extensive criticism, a new draft has been submitted by the Federal Ministry of the Interior and published by the German Association for Data Protection and Data Security on November 11, 2016 (the “Draft“). Section 24 of the Draft concerns the processing of employee data and basically corresponds to the current section 32 FDPA, but includes a legal definition of “employee” in section 24 (3) of the Draft. However, as section 24 of the Draft only concerns the admissibility of processing employee data, it seems questionable whether section 24 meets the requirements of Art. 88 (2) GDPR which stipulates that such rules shall include specific measures to safeguard certain employee interests. Further, sections 30 – 35 of the Draft reduce the information obligations of the data controller (i.e. the body which determines the purposes and means of the data processing) provided by Art. 13 and 14 GDPR on the one hand, and on the other hand, limit the data subject’s rights as laid down in Art. 14 et. seq. GDPR. Some of these restrictions have not been envisioned by the European legislator. It is also striking that section 40 of the Draft sets an upper limit of EUR 300.000 for administrative fines imposed on natural persons exercising their duties for the data processor or controller, although Art. 83 (1) GDPR requires “effective, proportionate and dissuasive” fines. Art. 83 (4) and (5) GDPR stipulate that, depending on which GDPR provision is infringed, the administrative fine shall either not exceed EUR 10.000.000 / EUR 20.000.000 or, in case of an undertaking, shall be calculated on the basis of 2% / 4% of the undertaking’s total worldwide annual turnover of the preceding financial year. Although the legislator obviously intends to make data protection requirements easier for the economy, it is questionable whether this draft will achieve this goal. At the moment it is not even foreseeable if this draft will pass the German Parliament. Even if it does, the resulting law would be highly complex and will cause many uncertainties for companies which are unfamiliar with data protection law – especially in combination with the provisions of the GDPR. Especially for companies operating throughout Europe, it seems advisable to adopt measures in compliance with the GDPR until the legislative developments in Germany gain greater predictability. Back to Top 6.2       Data Protection – International Data Transfers Following the invalidation of the EU-U.S. Safe Harbor framework by the Court of Justice of the European Union (“CJEU“) in October 2015, uncertainty about the lawfulness of personal data transfers to the US existed among affected companies. This has only changed since the adoption of the EU-U.S. Privacy Shield on July 12, 2016 by the European Commission as Safe Harbor’s succession regime. However, until the European Commission publishes new model contracts (standard contractual clauses – “SCC“), the current SCC as published by the European Commission remain a possible alternative for the transfer of personal data to third countries under the Privacy Shield regime. The extent to which the European Commission will publish new SCCs is currently unclear. It is expected that only those SCCs governed by the respective Member State laws will be amended in the near future. Meanwhile, the data protection authority in Hamburg has imposed fines of EUR 8.000 (approximately US$ 8,500) on a US software company, EUR 9.000 (approximately US$ 9,500) on a beverage producer and of EUR 11.000 (approximately US$ 11,700) on the world’s largest producer of consumer goods for the continuing transfer of personal data based on the invalidated Safe Harbor framework instead of reverting to available legal alternatives. Although these fines are rather modest, they were the first of their kind and are intended to send a signal to other companies that German Data Protection Authorities (“DPAs“) will pursue investigations and sanction data transfers based on the Safe Harbor regime with fines and – more importantly – prohibition orders. Back to Top 6.3       Data Protection – Collective Actions for Injunctions The German legislator has adopted an act amending the German Act Governing Collective Actions for Injunctions (Unterlassungsklagengesetz – UKlaG) which entered into force in February 2016. The main achievement of this amendment is that, in addition to the federal and state DPAs, consumer organizations and the chamber of commerce and competition now have legal standing to bring collective injunction proceedings for infringements of data protection law on behalf of consumers. Back to Top 7.      Compliance 7.1       Compliance – Proposed Reform of Public Recovery of Criminal Assets On July 13, 2016, the German federal government passed a draft bill to comprehensively reform the public recovery of criminal assets (Entwurf eines Gesetzes zur Reform der strafrechtlichen Vermögensabschöpfung). The draft bill which still needs to pass both German legislative bodies (Bundestag and Bundesrat) before entering into force will implement the European Directive 2014/42/EU of April 3, 2014 into German domestic law, but exceeds the scope of the EU directive considerably. One of the draft bill’s major changes is abolishing Section 73 Subsection 1 Sentence 2 of the German Criminal Code (Strafgesetzbuch), which provides that a victim’s right to asset recovery under civil law prevails over confiscation through a criminal court order. Under the new draft bill, any type of asset recovery would be conducted exclusively by the state authorities. Such general incorporation of asset recovery into criminal proceedings – including related civil law aspects – has been subject to severe criticism, because it deprives victims of their right to take civil legal action and thereby forces them to wait to assert further claims until the related criminal proceedings have been concluded. Moreover, under the new framework, a victim will be bound by the limitation periods set out in the German Criminal Code, which are often significantly shorter than those under civil law. The draft bill also suggests that assets of unclear origin may be confiscated without specific evidence if a court is convinced – in particular in view of an evident discrepancy of the value of the assets and the rightful earnings of the individual – that they were obtained from an illegal activity and if the investigation relates to certain enumerated offenses (e.g., organized crime and terrorism). The draft bill’s reasons specifically reference the comparable U.S. concept of “non-conviction-based confiscation/forfeiture.” The draft bill also contains guidance for calculating illegal profits in the context of insider trading activities. Specifically, it provides that those convicted of insider trading cannot deduct the original purchase price of stock subject to confiscation (draft of revised Section 73d Subsection 1 Sentence 2 of the German Criminal Code). This approach suggests that the recovery of assets is no longer a mere administrative measure but also includes a penalizing element. Back to Top 7.2       Compliance – Court Ruling on Seizure of Documents from Law Firms On March 16, 2016, the District Court of Bochum handed down a noteworthy decision regarding the seizure of documents from a law firm (Landgericht Bochum, Order from March 16, 2016, file reference 6 Qs 1/16). According to Section 97 Subsection 1 Number 3 German Code of Criminal Procedure (Strafprozessordnung), objects are, among other things, not subject to seizure if they are covered by an attorney’s right to refuse to testify. This right only applies to information that was entrusted to or became known to the attorney in his capacity as an attorney. The Bochum court ruled that this legal provision applies exclusively to the trusted relationship between a criminally accused person and someone who is granted the right to refuse to testify, meaning that it does not protect the relationship between someone who is not accused of a crime and any custodian of professional secrets, such as an attorney. The case relates to a public prosecutor’s investigation of a managing director suspected of having received kick-backs. According to the complaint, the company’s ombudswoman, an external attorney, had received relevant information from a whistleblower, but did not disclose it to the investigators. Upon final seizure of the documentation by the public prosecutor, the ombudswoman filed an appeal claiming a violation of the respective statutory restrictions arising from her capacity as an attorney and the whistleblower’s trust in her professional confidentiality obligation. In addition to the court’s finding that the law did not protect the relationship between the non-accused, anonymous whistleblower and the attorney, the court noted that the attorney was acting on behalf of the company in her capacity as ombudswoman, which prevented the establishment of a privileged relationship between her and the whistleblower. Companies often designate external attorneys as ombudspersons to ensure that allegations conveyed to an ombudsperson are fully privileged and thus protected from access by state authorities. The Bochum decision now calls into question whether this approach is sound for Germany. Companies affected by this ruling will have to assess what additional protective measures they can provide to potential whistleblowers. Back to Top 7.3       Compliance – German Federal Constitutional Court on Extradition to the United States A recent decision by the German Federal Constitutional Court (Bundesverfassungsgericht) may be of crucial importance for future extraditions between Germany and the United States in multi-jurisdictional matters. In March 2016, the German Federal Constitutional Court remitted a 2015 ruling by the Higher District Court of Frankfurt am Main (Oberlandesgericht Frankfurt am Main) which in the constitutional court’s view disregarded applicable key principles of the German Constitution and as a consequence stopped the deportation of a Swiss national from Germany to the United States. The Federal Constitutional Court’s ruling took issue with a 2015 decision by the U.S. Court of Appeals for the Second Circuit in United States v. Suarez regarding the contours of the Principle of Specialty under international law. For the sake of international comity, the Principle of Specialty generally requires a country seeking extradition to adhere to any limitations placed on prosecution by the surrendering country. In interpreting this principle, the US court in the Suarez case had held that an extradited person lacks standing to challenge the requesting nation’s adherence to the doctrine absent an official protest by the extraditing nation. Because German law requires courts to assess whether a requesting nation adheres to the Principle of Specialty before extraditing a person in German custody to that nation, the Federal Constitutional Court noted its disapproval with the Suarez decision in holding that the complainant could not be extradited to the United States. Specifically, it held that the mere reference to the opportunity of requesting the extraditing nation to raise an official protest generally violates fundamental rights of the German Constitution (Grundgesetz, GG), namely the right to personal freedom (Article 2 subsection 2) and, in any case, violates the guarantee of general freedom of action (Article 2 subsection 1 of the German Constitution). Back to Top 8.      Antitrust and Merger Control 8.1       Merger Control 8.1.1    Adjustment to Thresholds in German Merger Control Cases On September 28, 2016, the German government adopted a draft bill for the ninth amendment to the German Act Against Restraints of Competition (Gesetz gegen Wettbewerbsbeschränkungen -“GWB”). The draft bill provides in respect of Section 35 GWB for additional thresholds for German merger control proceedings before the Bundeskartellamt. If the draft is adopted in its current form, mergers which cumulatively meet the following requirements are subject to notification and additionally may require approval by the Bundeskartellamt: (i)    At least one of the merging parties generated a domestic turnover of more than EUR 25 million in the last business year, but no other merging party generated a domestic turnover of more than EUR 5 million; (ii)   the consideration for the merger is more than EUR 400 million; and (iii)  the activities of the company being acquired in the domestic market are substantial in the sense laid out in (i). Back to Top 8.1.2    Tengelmann Merger The Edeka/Kaiser´s Tengelmann merger was finalized at the beginning of December 2016. For more details on this merger please refer to our 2016 Antitrust Merger Enforcement Update and Outlook. Just a few days after the Minister for Economic Affairs Sigmar Gabriel had granted his ministerial approval (Ministererlaubnis) to the merger, the major competitors of the merging parties, REWE, Markant and Norma, appealed against this decision. On July 12, 2016 the Higher District Court of Düsseldorf (Oberlandesgericht Düsseldorf) held the Ministererlaubnis to be unlawful and therefore suspended it by way of an interim injunction. One of the reasons given by the court was bias by the Minister of Economic Affairs. Subsequently, Edeka challenged the Higher District Court’s decision not to allow an appeal. After several weeks of negotiations, Markant and Norma declared their agreement to the merger by withdrawing their appeals. After some mediation talks led by former German chancellor Gerhard Schröder, REWE and Edeka finally reached an agreement on the merger. Since its introduction in 1973, only eight mergers have been approved by a Ministererlaubnis. Since then the Ministererlaubnis has been subject to ample controversy in legal literature, in particular because the grant decision is not based on competition law considerations and may potentially interfere with the Bundeskartellamt’s work. The Edeka/Kaiser’s Tengelmann merger has fueled the discussion anew due to the fact that the Minister’s main reasoning was to secure jobs at Kaiser’s Tengelmann which is arguably not a very strong consideration for granting a Ministererlaubnis. However, as is shown by the ninth amendment to the GWB, the German regulator has no intention of reforming or abandoning the concept of the Ministererlaubnis. Back to Top 8.2       Antitrust and Merger Control – Private Antitrust Litigation 8.2.1    Legislative Reform The ninth amendment to the GWB will also implement the European Damages Directive. Some of the implementing provisions were already mentioned in our 2016 Mid-Year Criminal Antitrust and Competition Law Update. Apart from this, the amendment also includes provisions on the availability of the passing-on defense which allows defendants to prove that the claimant did not suffer any damages because he was able to pass on the cartel overcharge to his own customers (indirect customers). The passing-on of cartel overcharges is refutably presumed if (i) the defendant infringed section 1 / 19 GWB or Art. 101 / 102 TFEU, (ii) such infringement resulted in an overcharge for the defendant’s direct customers, and (iii) the indirect customer has purchased goods or services that were the object of the infringement, or that derived from or contained goods or services which were the object of the infringement. Further, the draft stipulates certain exceptions to the principle of joint and several liability of cartelists for cartel damages in relation to (i) internal regress, (ii) leniency applicants, and (iii) settlements between cartelists and claimants. In the latter case, non-settling cartelists may not recover contribution for the remaining claim from settling cartelists. The draft also foresees a rather broad section on the disclosure of evidence which is foreign to principles of German civil procedure. As a rule, pursuant to the German Code of Civil Procedure (Zivilprozessordnung, ZPO), the party relying on a fact has to produce the relevant evidence. Only sections 142 and 422 ZPO relate to the other party’s obligation to produce evidence – in both cases limited to specific, and precisely identified or identifiable documents. Section 33g GWB of the draft bill, however, broadens this scope substantially by referring to evidence which is necessary to bring a damages action in general – not just specific documents, and by reducing the aforementioned designation requirements to the extent to which a claimant is reasonably able to identify the evidence with the information available to him. Considering that a substantial amount of evidence in damages actions for competition law infringements is usually held by the defendant, this could potentially include a large number of documents relating to the defendant’s pricing and business strategies. The implementation of the ninth amendment is expected to substantially lessen the burden and difficulties claimants faced in past damages actions for competition law infringements. Back to Top 8.2.2    Case Law In 2016, there were a few noteworthy decisions in relation to private competition law enforcement in Germany, most of which clarified the extent of evidence a claimant has to present to the court in order to succeed with a damages claim. For the first time since 2011 the German Federal Supreme Court (Bundesgerichtshof, BGH) ruled on some of the open questions in private competition law enforcement in its Lottoblock II decision of July 12, 2016 (BGH, KZR 25/14). In Lottoblock II the Bundesgerichtshof held: (i)    Only the operational part and reasoning on which the decision by a competition authority is based are binding on German courts pursuant to section 33 (4) GWB. (ii)   Once a concerted practice is concluded, there is a rebuttable presumption that cartelists abide by such practice, as long as it exists and the cartelists remain active on the relevant market. The presumption may be rebutted if essential economic and legal market factors change and at least one of the cartelists clearly and recognizably distances itself from the concerted practice. (iii)  The question whether the claimant provided sufficient evidence to prove that he was affected by the cartel needs to meet the standards set out in section 286 ZPO. Therefore, the claimant has to provide enough evidence to allow the judge to form a confident opinion on the facts. However, the existence of a concerted practice may constitute prima facie evidence pursuant to section 287 ZPO that the anticompetitive conduct caused damage. On November 19, 2015 the District Court Düsseldorf (Landgericht Düsseldorf, case no.: 14 d O 4/14) ruled on damage claims brought by indirect customers of the Autoglas cartel. It held that the question whether a cartel overcharge has been passed on to indirect customers forms part of the assessment whether the claimant was affected by the cartel and thus needs to meet the standards of evidence laid out in section 286 ZPO. On November 9, 2016 the Higher District Court Karlsruhe (Oberlandesgericht Karlsruhe, case no.: 6 U 204/15 Kart (2)) held that for cartels with significant market coverage and of a longer duration there is prima facie evidence that the cartel had an impact on market prices which were not subject to the cartel (so-called umbrella pricing) because such prices, too, will be set with respect to attainable market prices. However, where market conditions are transparent and mutual observation occurs, significant market coverage (irrespective of the duration of the cartel) is sufficient for such prima facie evidence. Furthermore, the court held that the probability of damage is not excluded by the fact that the damage has been passed on to the end consumer (so-called passing-on-defense). On September 8, 2016 the District Court Düsseldorf (Landgericht Düsseldorf, case no.: 37 O 27/11 [Kart]) ruled on the liability of parent companies. Even if a parent company has been held jointly and severally liable for its subsidiary’s anticompetitive conduct pursuant to European competition law principles, such liability does not apply to damages claims based on German tort law. On the contrary, the separation principle, whereby a legal entity is liable only with its own assets, prevails. Back to Top 8.3       Antitrust and Merger Control – Cartel Enforcement – Corporate Liability Moreover, the aforementioned draft bill for the ninth amendment to the GWB brings a company’s liability in line with the existing European model. According to this model, parent companies can be held liable for their subsidiary’s anti-competitive conduct even if they were not party to the infringement themselves. Provided that, at the time of the infringement, the parent company and the subsidiary form a single economic unit allowing the parent company to exercise decisive influence over the conduct of its subsidiary, the parent company can be held jointly and severally liable for the administrative fine. There is a rebuttable presumption that the parent company exercises decisive influence in case of wholly owned subsidiaries, but decisive influence can also be established by other factors. Further, the legislative gap known as the so-called “sausage gap” is being closed. This gap became apparent and was named after a decision of the Bundeskartellamt in October 2016, pursuant to which the Bundeskartellamt had to conclude its proceedings against two sausage manufacturing companies due to the fact that these companies no longer existed following internal restructuring measures (press release of October 19, 2016; available here). Thus, even though the parent corporation still existed, the fines imposed on the two subsidiaries in 2014 could no longer be enforced. The fines would have been in the amount of EUR 128 million (approximately US$ 136 million). According to the draft bill, future fines may also be imposed on the legal universal successor as well as the economic successor of the company that infringed competition law. Back to Top 8.4       Antitrust and Merger Control – Cartel Prosecution In December 2016, the Bundeskartellamt concluded its last proceedings for vertical price fixing in the retail food market (press release of December 15, 2016; available here). It imposed fines of EUR 18.3 million (approximately US$ 19,1 million) on several food retailers for fixing retail beer prices. In 2015 and 2016 the Bundeskartellamt imposed fines on one brewery and eleven retailers for vertically fixing beer prices amounting to a total of approximately EUR 112 million (approximately US$ 117 million). Back to Top The following Gibson Dunn lawyers assisted in preparing this client update:  Benno Schwarz, Birgit Friedl, Marcus Geiss, Silke Beiter, Peter Decker, Lutz Englisch, Ferdinand Fromholzer, Daniel Gebauer, Kai Gesing, Johanna Hauser, Lukas Inhoffen, Julia Langer, Sebastian Lenze, Annekatrin Pelster, Wilhelm Reinhardt, Sonja Ruttmann, Martin Schmid, Michael Walther, Jutta Wiedemann, Mark Zimmer and Caroline Ziser Smith. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding the issues discussed in this update. The two German offices of Gibson Dunn in Munich and Frankfurt bring together lawyers with extensive knowledge of corporate, tax, labor, real estate, antitrust, intellectual property law and extensive compliance / white collar crime experience. The German offices are comprised of seasoned lawyers with a breadth of experience who have assisted clients in various industries and in jurisdictions around the world. Our German lawyers work closely with the firm’s practice groups in other jurisdictions to provide cutting-edge legal advice and guidance in the most complex transactions and legal matters. For further information, please contact the Gibson Dunn lawyer with whom you work or any of the following members of the German offices: General Corporate, Corporate Transactions and Capital Markets Lutz Englisch (+49 89 189 33 150), lenglisch@gibsondunn.com) Markus Nauheim (+49 89 189 33 122, mnauheim@gibsondunn.com) Ferdinand Fromholzer (+49 89 189 33 121, ffromholzer@gibsondunn.com) Dirk Oberbracht (+49 69 247 411 510, doberbracht@gibsondunn.com) Wilhelm Reinhardt (+49 69 247 411 520, wreinhardt@gibsondunn.com) Birgit Friedl (+49 89 189 33 121, bfriedl@gibsondunn.com) Silke Beiter (+49 89 189 33 121, sbeiter@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Annekatrin Pelster (+49 69 247 411 521, apelster@gibsondunn.com Finance, Restructuring and Insolvency Birgit Friedl (+49 89 189 33 121, bfriedl@gibsondunn.com) Marcus Geiss (+49 89 189 33 122, mgeiss@gibsondunn.com) Tax Hans Martin Schmid (+49 89 189 33 110, mschmid@gibsondunn.com) Labor Law Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Real Estate Peter Decker (+49 89 189 33 115, pdecker@gibsondunn.com) Daniel Gebauer (+ 49 89 189 33 115, dgebauer@gibsondunn.com) Technology Transactions / Intellectual Property / Data Privacy Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com) Corporate Compliance / White Collar Matters Benno Schwarz (+49 89 189 33 110, bschwarz@gibsondunn.com) Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Mark Zimmer (+49 89 189 33 130, mzimmer@gibsondunn.com) Antitrust and Intellectual Property Michael Walther (+49 89 189 33 180, mwalther@gibsondunn.com) Kai Gesing (+49 89 189 33 180, kgesing@gibsondunn.com)     © 2017 Gibson, Dunn & Crutcher LLP   Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 11, 2016 |
IRS Issues Final and Proposed Regulations Addressing Partnerships and Section 956 and the Active Rents and Royalties Exception

On November 3, 2016, the Internal Revenue Service (the "IRS") and the Treasury Department ("Treasury") issued final regulations (the "Final Regulations") providing rules regarding the treatment under section 956 of "United States property" held by controlled foreign corporations ("CFC") through partnerships and expanding the scope of the section 956 anti-avoidance rule.  Along with the Final Regulations, the IRS and Treasury also issued proposed section 956 regulations (the "Proposed Regulations") addressing certain determinations regarding related parties.  The Final Regulations also contain rules for determining whether a CFC is considered to derive rents and royalties in the active conduct of a trade or business for purposes of determining whether the CFC has earned foreign personal holding company income ("FPHCI").  The Final Regulations generally adopt, with some changes, the temporary and proposed regulations that were issued on September 2, 2015 (the "2015 Temporary Regulations" and the "2015 Proposed Regulations," respectively), and also withdraw Revenue Ruling 90-112.  The Final Regulations are effective beginning November 3, 2016.  The Proposed Regulations are proposed to be effective for tax years of CFCs ending on or after the Proposed Regulations are finalized. Background I.    Section 956 Under section 956, a U.S. shareholder (as defined in section 951(b)) must include in gross income its pro rata share of a CFC’s investment in U.S. property.  The amount of a CFC’s investment in U.S. property is determined, in part, based on the average of the amounts of U.S. property held, directly or indirectly, by the CFC at the close of each quarter during its taxable year.  Generally, the amount taken into account with respect to any U.S. property is the adjusted basis of the property, reduced by any liability to which the property is subject.[1]  Although existing regulations under section 956 provided that a CFC-partner is treated as holding its proportionate share of a partnership’s U.S. property,[2] before the issuance of the Final Regulations, there was no meaningful guidance regarding how to determine a CFC-partner’s share of the U.S. property held by a partnership.  In addition, although Revenue Ruling 90-112 limited a CFC-partner’s share of a partnership’s U.S. property to the CFC-partner’s adjusted basis in its partnership interest (its "outside basis"), and it was widely accepted by taxpayers and the tax bar that this outside basis limitation had been incorporated into the Treasury regulations, the government had never formally confirmed this point. Under section 956(c), U.S. property includes an obligation of a U.S. person, and, under section 956(d) and Treas. Reg. § 1.956-2(c), a CFC is treated as holding an obligation of a U.S. person if the CFC is a pledger or guarantor of the obligation.  Therefore, if a CFC makes or guarantees a loan to a U.S. person, an income inclusion may be required with respect to the CFC under sections 951(a)(1)(B) and 956.  Under section 956, U.S. property also includes certain receivables acquired by a CFC from U.S. persons acquired in certain related party factoring transactions.[3] Before the issuance of the 2015 Temporary Regulations, the anti-avoidance rule provided that a CFC is considered to hold indirectly investments in United States property acquired by any other foreign corporation that is controlled by the CFC if one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) the other foreign corporation was to avoid the application of section 956 with respect to the CFC.  The 2015 Temporary Regulation modified the anti-avoidance rule so that the rule also applies when a foreign corporation controlled by a CFC is funded other than through capital contributions or debt and expanded the rule to apply to transactions involving partnerships that are controlled by a CFC. II.    Foreign Personal Holding Company Income The regulations under section 954 provide "developer exceptions" and "active marketing exceptions," whereby rental and royalty income of a CFC are excluded from FPHCI if the income is derived by the CFC from leasing or licensing property in an active trade or business.  The 2015 Temporary Regulations, in an effort to more clearly distinguish between passive investment income and active business income, inserted the words "through its own officers or staff of employees" three times throughout Temp. Treas. Reg. § 1.954-2T. Thus, the developer exceptions, as modified by the 2015 Temporary Regulations, referred to property that the CFC, through its own officers or staff of employees, has manufactured or developed or created or produced, or has acquired and, through its own officers or staff of employees, added substantial value to, but only if the CFC, through its own officers or staff of employees, is regularly engaged in the manufacture or development or creation or production of, or in the acquisition of and addition of substantial value to, property of such kind. The Final and Proposed Regulations I.    Partnership Property Held by a CFC Through a Partnership           A.    Calculation of Partner’s Attributable Share of Partnership Property:  Liquidation Value Percentage The Final Regulations provide that the amount of U.S. property attributed to a CFC partner from a partnership is determined by reference to the partner’s "liquidation value percentage," or "LVP," i.e. a percentage based on a partner’s rights to cash on the sale by the partnership of all of its assets, the settling of its liabilities, and the distribution of the remaining proceeds to the partners.[4]  The Final Regulations retain the rule from the 2015 Proposed Regulations that the determination of a partner’s LVP takes into account special allocations, as long as the special allocation does not have the principal purpose of avoiding the application section 956.  For purposes of section 956, allocations pursuant to section 704(c) are not special allocations.[5]    Generally, a partner’s LVP must be re-determined upon a "revaluation" event specified in the section 704(b) regulations.[6]  (Those events include certain contributions, distributions, issuances of compensatory equity, and exercises of partnership options and conversion rights.[7])  In response to comments that partners’ relative economic interests in the partnership may change significantly as a result of allocations of income or other items under the partnership agreement even in the absence of a revaluation event, the Final Regulations provide that a partner’s liquidation value percentage must be re-determined in certain additional circumstances.  Specifically, if the LVP determined for any partner on the first day of the partnership’s taxable year would differ from the most recently determined LVP of that partner by more than 10 percentage points, then the LVP must be re-determined on that day even in the absence of a revaluation event. The IRS and Treasury also issued Proposed Regulations that would eliminate the ability to take into account special allocations when applying the LVP method with respect to any partner that controls the partnership.  For this purpose, a partner is treated as controlling a partnership if the partner and the partnership are related within the meaning of section 267(b) or section 707(b), substituting "at least 80 percent" for "more than 50 percent."  The Proposed Regulations, if finalized, would mark a dramatic change in the tax law by disregarding the effect of valid special allocations.           B.    Outside Basis and Revenue Ruling 90-112  Under the Final Regulations, the amount of a partnership’s U.S. property that is attributed to its partners is based upon the partnership’s basis in the property without regard to the partner’s basis in its partnership interest.[8]  Revenue Ruling 90-112, which limited the amount of U.S. property attributed to the partner to its outside basis, is obsolete as of November 3, 2016.  Accordingly, taxpayers no longer can rely on outside basis to limit the amount of U.S. property held by a CFC indirectly through a partnership, although taxpayers may rely on the outside basis limitation for tax years ending before November 3, 2016. The IRS and Treasury eliminated the outside basis limitation because they were concerned that a limitation determined by reference to a partner’s outside basis was less consistent with section 956(a), which provides that the amount of U.S. property directly or indirectly held by a CFC is determined by reference to the adjusted basis of the U.S. property itself, and further, that, under the partnership tax rules of subchapter K, adjustments may be made to outside basis through the allocation of liabilities under section 752 that are inconsistent with the policy of section 956.  In our view, though such concerns may be justified, removing the outside basis limitation may place taxpayers in the incongruous position of having inclusions under section 956 when they hold property indirectly through a partnership, where they would not have inclusions if they held the property directly.  It should be noted that incongruities in the tax law, while being traps for the unwary, often lead to planning opportunities.              C.    Obligations of Foreign and Domestic Partnerships                         1.    Generally       The Final Regulations generally treat the obligations of a foreign partnership as obligations of its partners by reference to the partner’s LVP.[9]  As a result, if a CFC holds an obligation of a foreign partnership, and one or more of the partners is a U.S. person, then the obligation will be treated as an obligation of a U.S. person for purposes of section 956, which could result in a section 956 inclusion by the U.S. shareholder of the CFC.  Under an important exception, however, the partners will not be treated as obligors under a partnership’s obligations if neither the CFC that holds the obligation nor any person related (within the meaning of section 954(d)(3)) to the CFC is a partner in the partnership on the CFC’s quarterly measuring date under section 956.[10]  The Final Regulations also provide that an obligation of a domestic partnership is in all cases treated as an obligation of a U.S. person.[11]                         2.    Funding Transactions The Final Regulations include a special "funded distribution" rule that applies to situations in which (1) a CFC makes a loan to a partnership, (2) the partnership makes a distribution to a partner who is related (within the meaning of section 954(d)(3)) to the CFC (a "related CFC"), and (3) the distributee-partner is a person whose obligation would be treated as U.S. property if held by the CFC, and (4) the partnership would not have made the distribution "but for" the funding of the partnership by the CFC.  If all four requirements are satisfied, the distributee-partner’s share of the partnership’s obligation is the greater of (i) its share under the LVP method or (ii) the lesser of (x) the amount of the distribution that would not have been distributed but for the funding and (y) the amount of the obligation.  Under the Final Regulations, the "but for" requirement is deemed to be satisfied to the extent that, immediately before the distribution, the partnership would not have had sufficient liquid assets to make the distribution if it had not incurred the obligation to the related CFC.  D.    Factoring Transactions The Final Regulations also finalize the 2015 Proposed Regulations under Treas. Reg. § 1.956-3, as well as proposed regulation issued on June 4, 1988, both of which addressed various factoring transactions.  Specifically, the Final Regulations provide rules for treating indirect acquisitions of trade or service receivables as having been acquired by a CFC.  A CFC is treated as indirectly acquiring the trade or service receivable from a related U.S. person if the CFC participates in a lending transaction that results in (i) a loan to a U.S. person who purchases inventory property or services from a related U.S. person or (ii) the purchases of trade or service receivables from a related U.S. person, if the loan would not have been made or maintained on the same terms but for the corresponding purchase.  The amount of the U.S. property is the lesser of the amount of the loan and the purchase price.  The Final Regulations also treat a CFC as acquiring the trade or service receivable of a related U.S. person when the receivable is acquired from an unrelated person who acquired (directly or indirectly) the receivable from a person who is a related person to the acquiring person.  E.    Anti-Avoidance Rule The Final Regulations adopt the substantive rules of the 2015 Temporary Regulations and also include examples and a coordination rule. Substantive Rules.  Consistent with the 2015 Temporary Regulations, the anti-avoidance rule under the Final Regulations applies if the CFC funds a partnership that is controlled by the CFC.  For this purpose, a CFC is treated as controlling a foreign corporation or partnership if the CFC and the foreign corporation or partnership are related within the meaning of section 267(b) or section 707(b).  The Final Regulations also provide that in cases in which the funding was done for purposes of avoiding section 956, the term funding includes funding "by any means" – i.e. funding through a means other than capital contributions or debt. Examples of Funding Transactions.  In response to comments on the 2015 Temporary Regulations, the Final Regulations include examples that illustrate the distinction between funding transactions that are subject to the anti-avoidance rule and common business transactions to which the anti-avoidance rule does not apply. Coordination Rule.  Comments to the 2015 Proposed Regulations noted that a CFC could be treated as holding duplicative amounts of U.S. property as a result of a single partnership obligation under the general rule and the anti-avoidance rule.  As a result, the Final Regulations expand the coordination rule proposed in the 2015 Proposed Regulations to prevent a CFC from being treated as holding duplicative amounts of U.S. property under the anti-avoidance rule as a result of a partnership obligation. II.    Foreign Personal Holding Company Income The Final Regulations finalize definitions from the 2015 Temporary Regulations for determining whether rents and royalties are considered derived in the active conduct of a trade or business, in which case they are excluded from FPHCI.    [1]   Treas. Reg. § 1.956-1(e)(1).    [2]   Treas. Reg. § 1.956-1(b).    [3]   I.R.C. § 956(c)(3).    [4]   Treas. Reg. § 1.956-4(b).    [5]   Treas. Reg. § 1.956-4(b)(2)(ii).  The Final Regulations are silent on whether other required allocations, such as the "qualified income offset" under Treas. Reg. § 1.704-1(b)(2)(ii)(d) and the various allocations with respect to nonrecourse deductions required under Treas. Reg. § 1.704-2, constitute special allocations.    [6]   Treas. Reg. § 1.956-4(b)(2)(i)(B)(2).    [7]   Treas. Reg. §§ 1.704-1(b)(2)(iv)(f)(5), -1(b)(2)(iv)(s).    [8]   Treas. Reg. § 1.956-4(b)(1).    [9]   Treas. Reg. § 1.956-4(c)(1). [10]   Treas. Reg. § 1.956-4(c)(2). [11]   Treas. Reg. § 1.956-4(e). The following Gibson Dunn lawyers assisted in the preparation of this client alert:  Eric Sloan, Jeff Trinklein and Nina Xue. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group: Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, apasternak@gibsondunn.com)Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com)Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)David B. Rosenauer - New York (+1 212-351-3853, drosenauer@gibsondunn.com)Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com)Romina Weiss - New York (+1 212-351-3929, rweiss@gibsondunn.com)Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com)Hatef Behnia – Los Angeles (+1 213-229-7534, hbehnia@gibsondunn.com)Paul S. Issler – Los Angeles (+1 213-229-7763, pissler@gibsondunn.com)Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com)Scott Knutson – Orange County (+1 949-451-3961, sknutson@gibsondunn.com)David Sinak – Dallas (+1 214-698-3107, dsinak@gibsondunn.com)      © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 9, 2016 |
IRS Releases Final Regulations Clarifying the Definition of Real Property for REITs

On August 31, 2016, the Internal Revenue Service (the "IRS") and the Department of the Treasury ("Treasury") issued final regulations clarifying the definition of "real property" for real estate investment trust ("REIT") purposes.  The final regulations largely follow the proposed regulations issued in May 2014, with limited changes.  The IRS and Treasury received numerous written and electronic comments and held a public hearing on the proposed regulations, but declined to incorporate most comments into the final regulations.  We have summarized below a general overview of the final regulations and some noteworthy features and observations. General Overview of the Final Regulations One of the requirements that a taxpayer must satisfy to qualify as a REIT is that, at the close of each quarter, at least 75 percent of the value of its total assets must be represented by real estate assets, cash and cash items, and government securities.  Under the Internal Revenue Code, "real estate assets" include real property (including interests in real property and interests in mortgages on real property).  The final regulations define the term "real property" for purposes of this quarterly asset test, as well as for other relevant REIT purposes, through the following series of defined terms: "Real property" includes "land" and "improvements to land." "Land" includes air space and water space superjacent to land (even if the taxpayer owns only the air space or water space and does not own an interest in the underlying land) and natural products (e.g., crops, water, ores and minerals) that have not been severed from the land. "Improvements to land" means "inherently permanent structures" and their "structural components." An "inherently permanent structure" is any permanently affixed "building" or "other inherently permanent structure." Affixation may be to land or to another inherently permanent structure and may be by weight alone. A "building" is a structure that encloses a space within its walls and is covered by a roof, such as a house or warehouse.  It’s worth noting that an open air stadium does not qualify as a building because it does not have a roof, but it may qualify as real property as an other inherently permanent structure. An "other inherently permanent structure" is a structure that is permanently affixed to land or to another inherently permanent structure and that serves a passive function (e.g., supporting or sheltering) rather than an active function (e.g., manufacturing or producing). The regulations specifically identify cell transmission towers, silos and oil and gas storage tanks, among others, as other inherently permanent structures as long as they are permanently affixed.  The final regulations make clear that the list of qualifying assets contained in the regulations is not all-inclusive.  Therefore, other assets may qualify as other inherently permanent structures if they meet a facts and circumstances test described in the final regulations. "Structural components" are distinct assets that are integrated into an inherently permanent structure, serve the structure in its passive function, and even if capable of producing income (other than as consideration for the use or occupancy of space), do not produce or contribute to the production of any such income.  Whether a distinct asset is a structural component is determined under a facts and circumstances test.  For example, while an elevator in an office building may transport people (an active function), it can qualify as a structural component as it facilitates the occupancy of space in the building (a passive function) and generally would not produce or contribute to the production of income other than for the use or occupancy of space.  Moreover, for a structural component (e.g., an air-conditioning system) owned by a REIT to qualify as an interest in real property, the REIT must also have an ownership interest in the inherently permanent structure that the structural component serves (e.g., the building in which the component is installed).  In addition, if a REIT holds an interest in a mortgage secured by a structural component, that mortgage will be treated as a real estate asset only if the mortgage is also secured by a real property interest in the inherently permanent structure that the component serves.   Noteworthy Features and Observations Mixed Guidance about Solar Energy Systems A number of commenters had suggested that solar panels should be included within the definition of real property (as inherently permanent structures).  In finalizing the proposed regulations, the IRS and Treasury rejected those comments, affirming the view that solar panels generally are active business assets that are not, standing alone, real property, though the final regulations note that the mounts for the solar panels and exit wires may qualify as real property under the facts and circumstances test applicable to other inherently permanent structures. In contrast, certain smaller-scale solar energy systems that are designed to serve a single building owned by a REIT may be eligible to be treated as structural components under the final regulations, at least where the quantity of any excess electricity transferred to the local utility company during the year does not exceed the quantity of electricity purchased from the local utility for the same year.  The preamble to the final regulations notes that the IRS and Treasury are still considering under what circumstances a sale of excess electricity to a utility would impact the classification of a solar energy system as a structural component.  As a result of the prevalence of such sales and the lack of clarity regarding when a solar system will qualify as real property, the final regulations leave a cloud of uncertainty over whether a REIT’s investment in solar energy systems will be treated as investments in real property. Passive Transport Assets are Potentially Real Property The proposed regulations had indicated that assets serving a transport function were not real property as a result of serving an active function.  The final regulations retain the concept that transport is an active function, but the preamble to the final regulations clarifies that transport means to cause to move.  Examples in the final regulations make clear that providing a conduit (e.g., a pipeline) or route (e.g., a road or railroad track) is a permitted passive function, but note that equipment like compressors that facilitate the movement of gas in a pipeline are not structural components.  The clarification of the meaning of transport should be helpful for REITs investing in certain energy and infrastructure assets.  Indefinite Inherently Permanent Structure Requirement Clarified The proposed regulations required that to qualify as real property, an inherently permanent structure that is affixed to real property must be expected to be affixed indefinitely.  Commenters had expressed concern that a structure would need to be affixed forever to satisfy this requirement.  The final regulations retain this requirement, but the preamble to the final regulations clarifies that the IRS and Treasury do not believe that a structure must be affixed forever to be an inherently permanent structure, stating that the relevant inquiry is whether the facts and circumstances indicate that the structure will be affixed indefinitely to land or another inherently permanent structure. Additions to Enumerated List of Inherently Permanent Structures The final regulations expand on the list of structures that are buildings that, if permanently affixed, qualify as real property, by adding to the list of buildings motels, enclosed stadiums/arenas and enclosed shopping malls.  Intangible Assets The final regulations confirm that an intangible asset is real property or an interest in real property if the asset derives its value from real property, is inseparable from the real property, and does not independently produce or contribute to the production of income (other than income derived as consideration for the use or occupancy of space).  For example, a license or similar right that is solely for the use, enjoyment or occupation of land and that is in the nature of a leasehold or easement generally is an interest in real property, while a license to operate a business is not real property.  Commenters had requested that intangible assets related to above-market leases (where the REIT was the lessor) and below-market leases (where the REIT was the lessee) be conclusively treated as real property assets.  The IRS and Treasury rejected those comments, providing instead that an interest in an above-market or below-market lease is an intangible interest that qualifies as an interest in real property only to the extent that the lease derives its value from rents from real property.  An example to the final regulations makes clear that the value attributable to an above-market lease may be bifurcated and treated as partially an interest in real property and partially a non-real estate asset. Impact on Prior Private Letter Rulings One commenter to the proposed regulations had requested that the final regulations provide that taxpayers would be able to continue to rely on previously-issued private letter rulings, even if those rulings were inconsistent with the final regulations.  The IRS and Treasury explicitly rejected this request in the preamble to the final regulations, indicating that to the extent a previously issued letter ruling was inconsistent with the final regulations, the letter ruling would be revoked prospectively from the date of the final regulations.  Accordingly, REITs with letter rulings should review them carefully to confirm that the rulings are not inconsistent with the final regulations. The following Gibson Dunn lawyers assisted in preparing this client alert:  Brian Kniesly, Jeff Trinklein, Eric Sloan, Arthur Pasternak, Benjamin Rippeon, David Sinak, Paul Issler, Michael Cannon and Mark Dreschler. Gibson Dunn’s lawyers are available to assist with any questions you may have regarding these developments.  For further information, please contact the Gibson Dunn lawyer with whom you usually work or any of the following members of the Tax Practice Group: Art Pasternak - Co-Chair, Washington, D.C. (+1 202-955-8582, apasternak@gibsondunn.com)Jeffrey M. Trinklein - Co-Chair, London/New York (+44 (0)20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com)Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)David B. Rosenauer - New York (+1 212-351-3853, drosenauer@gibsondunn.com)Eric B. Sloan – New York (+1 212-351-2340, esloan@gibsondunn.com)Romina Weiss - New York (+1 212-351-3929, rweiss@gibsondunn.com)Benjamin Rippeon – Washington, D.C. (+1 202-955-8265, brippeon@gibsondunn.com)Hatef Behnia – Los Angeles (+1 213-229-7534, hbehnia@gibsondunn.com)Paul S. Issler – Los Angeles (+1 213-229-7763, pissler@gibsondunn.com)Dora Arash – Los Angeles (+1 213-229-7134, darash@gibsondunn.com)Scott Knutson – Orange County (+1 949-451-3961, sknutson@gibsondunn.com)David Sinak – Dallas (+1 214-698-3107, dsinak@gibsondunn.com)      © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

August 1, 2016 |
FinCEN Expands Temporary Reporting Requirements on Title Insurance Companies for All Cash Luxury Real Estate Transactions to Six Major U.S. Areas

On July 27, 2016, the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) announced an expansion of the Geographic Targeting Orders (GTOs) targeting alleged money laundering risk in the real estate sector.  Gibson Dunn published a comprehensive client alert on the original GTOs involving Manhattan and Miami-Dade County, Florida, in February 2016 (http://www.gibsondunn.com/publications/Pages/FinCEN-Imposes-Temporary-Reporting-Requirements-on-Title-Insurance-Companies–All-Cash-Luxury-RE-Transactions.aspx), which is supplemented by this client alert.  The original GTOs expire on August 27, 2016.    The new GTOs will temporarily require U.S. title insurance companies to identify the natural persons behind shell companies used to pay "all cash" for high-end residential real estate in six major metropolitan areas. In announcing the new GTOs, FinCEN explained that it remains concerned that all-cash purchases (i.e., those without bank financing) may be conducted by individuals attempting to hide their assets and identity by purchasing residential properties through limited liability companies or other similar structures.   The new GTOs will be effective on August 28, 2016 for 180 days and cover the following areas:  (1) all boroughs of New York City; (2) Miami-Dade County and the two counties immediately north (Broward and Palm Beach); (3) Los Angeles County, California; (4) three counties comprising part of the San Francisco area (San Francisco, San Mateo, and Santa Clara counties); (5) San Diego County, California; and (6) the county that includes San Antonio, Texas (Bexar County).  The monetary thresholds for each county vary from $500,000 to $3 million.  FinCEN published a table showing these thresholds here (https://www.fincen.gov/news_room/nr/files/Title_Ins_GTO_Table_072716.pdf).    In its press release, FinCEN explained that the initial GTOs have helped law enforcement identify possible illicit activity and are informing future regulatory approaches. In particular, FinCEN reported that a significant portion of covered transactions have indicated possible criminal activity associated with the individuals reported to be the beneficial owners behind shell company purchasers. Federal and state law enforcement agencies have also informed FinCEN that information generated by the GTOs has provided greater insight on potential assets held by persons of investigative interest and, in some cases, has helped generate leads and identify previously unknown subjects.  According to Treasury officials reported in The Wall Street Journal, more than a quarter of transactions reported in the original GTOs involved someone listed in at least one of the 17 million suspicious activity reports (SARs) filed with FinCEN by financial institutions since shortly after the September 11, 2001, terrorist attacks.         Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work, or the authors: Stephanie L. Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com)Joel M. Cohen – New York (+1 212-351-2664, jcohen@gibsondunn.com)Andrew A. Lance – New York (+1 212-351-3871, alance@gibsondunn.com)Judith A. Lee – Washington, D.C. (+1 202-887-3591, jalee@gibsondunn.com)Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)Amy G. Rudnick – Washington, D.C. (+1 202-955-8210, arudnick@gibsondunn.com)F. Joseph Warin – Washington, D.C. (+1 202-887-3609, fwarin@gibsondunn.com)Debra Wong Yang – Los Angeles (+1 213-229-7472, dwongyang@gibsondunn.com)Linda Noonan - Washington, D.C. (+1 202–887–3595, lnoonan@gibsondunn.com)Adam M. Smith – Washington, D.C. (+1 202-887-3547, asmith@gibsondunn.com) © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 25, 2016 |
Is It Still Possible to Implement Tax-Free Step-Up of Real Estate Assets Held Through a French SCI?

The Lupa decision creates uncertainty in applying the Quemener principle in a Luxembourg situation On July 6, 2016, the French Supreme Court rendered a surprising decision[1] that limits the right of tax payers to implement a tax-free step up of French real estate assets held through French SCIs (société civile immobilère). Such tax free step up is usually implemented pursuant to guidelines known as the Quemener principle. The Quemener principle seeks to  neutralize situations that would create either a double deduction or double taxation of SCI partners. Such situations arise because an SCI is a French tax transparent partnership: its taxable income is taxed in the hands of the partners at the end of each financial year, regardless of whether  such income is distributed to the shareholders of the SCI. The example below explains how the regime has historically operated. An SCI owns an asset with a 100 tax basis but a fair market value of 300. An investor purchases the SCI shares for 300. Following such purchase, the SCI implements a step-up of its asset from 100 to 300. As a result, the investor is taxed on a gain of 200. The SCI is dissolved and the SCI shares are cancelled. Pursuant to the Quemener principles, the investor is entitled to increase the tax basis of its SCI shares by the amount of the stepped up gain. As a result, the investor can offset its 200 taxable gain with the 200 capital loss that the investor will incur upon the cancellation of the SCI shares[2]. Following the SCI’s dissolution, the tax basis of the assets of the dissolved SCI in the books of the investor is 300. Since 2007, the published guidelines of the tax authorities have confirmed the application of the Quemener neutralization principles in the context of a voluntary step-up of the tax basis of an SCI’s assets (followed by a dissolution of such SCI). The French Supreme Court has also recently confirmed that these principles apply to the cancellation of shares in an  SCI following a step-up in the context of a tax reassessment as determined by French tax authorities [3]. Despite the longstanding guidelines of the tax authorities, in the Lupa decision dated 6 July 2016, the French Supreme Court concluded that the Quemener neutralization principles should only apply where the same gain (i.e., gain on the SCI shares and gain deriving from the step-up of the SCI’s asset) has been taxed twice at the level of the SCI’s partner. In that respect, the taxpayer’s argument regarding the existence of the economic equivalent of double taxation was rejected by the French Supreme Court and the Government Attorney. However, it is worth noting that the Lupa facts were very specific: Within a period of a few days, the French investor implemented a series of complex intragroup transfers and mergers between French and Luxembourg companies, which were timed to occur shortly before the execution of the 1st amendment to the France-Luxembourg tax treaty dated 24 November 2006 (this amendment  ended double exemption situations in the context of French real estate investments); The French investor implemented two basis step-ups: a step-up of the value of the SCI shares at a time where the SCI was held by a Luxembourg company, which itself had been acquired by the French investor. As a result of the provisions of the France-Luxembourg tax treaty applicable at such time, the step-up gain was not  taxed in France; a step-up of the value of the assets of the SCI at a time when the SCI had been transferred to the French investor as a result of the dissolution of the Luxembourg company. The SCI shares were transferred to the French investor as a result of the dissolution of a Luxembourg company, a dissolution that did not fall within the scope of French corporate income tax; The investor could not avail itself of the 2007 published guidelines of the tax authorities confirming the application of the Quemener neutralization principles in the context of a voluntary step-up of the tax basis of an SCI’s assets. Based on the context of the Lupa decision, and noting that the Quemener principles have been consistently applied by the French Supreme Court for  16 years since the landmark Quemener decision[4], the Lupa decision should most likely be viewed as a one-off decision that does not significantly narrow the scope of application of the Quemener principles (except for the situation where SCI shares have been revalued and transferred in a tax-free manner prior to their cancellation).  Nevertheless, given the uncertainty created by this decision, we recommend that our clients and friends pay careful attention to the evolution of the French published guidelines relating to the implementation of the Quemener principles.      [1]   CE 6 July 2016 n°377904 (Lupa)    [2]   Such loss being equal to the difference between 300 (the value of the net assets of the SCI upon the dissolution) and 500 (being the sum of the purchase price of the SCI shares of 300 and the step-up gain of 200)    [3]   CE 27 July 2015 n°362025    [4]   CE 16 February 2000 n°133296   Gibson Dunn lawyers are available to assist in addressing any questions you may have regarding these issues.  Please contact the Gibson Dunn lawyer with whom you usually work, the authors, Jérôme Delaurière or Jeffrey Trinklein, or any of the following lawyers: Jérôme Delaurière – Paris (+33 (0) 1 56 43 13 00, jdelauriere@gibsondunn.com)Jeffrey M. Trinklein - London/New York (+44 (0) 20 7071 4224 / +1 212-351-2344), jtrinklein@gibsondunn.com)Ariel Harroch – Paris (+33 (0) 1 56 43 13 00, aharroch@gibsondunn.com)Nicholas Aleksander – London (+44 (0) 20 7071 4232, naleksander@gibsondunn.com) Hans Martin Schmid – Munich (+49 (0) 89 189 33 110, mschmid@gibsondunn.com)  © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.